How Does a Forward Contract Differ from a Call Option?

07/31/2015 8:00 am EST

Focus: OPTIONS

The staff at Investopedia.com highlights the differences between forward contracts and call options, two financial instruments that can be used to hedge assets or speculate on the future prices of assets.

Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets at specified prices on future dates. Forward contracts and call options can be used to hedge assets or speculate on the future prices of assets.

Explaining the Differences Between Forward Contracts and Call Options

A call option gives the buy or holder the right, but not the obligation, to buy an asset at a predetermined price on or before a predetermined date, in the case of an American call option.
The seller or writer of the call option is obligated to sell shares to the buyer if the buyer exercises his option or if the option expires in-the-money.

For example, assume an investor purchases one call option contract on Apple, Inc. (AAPL) with a strike price of $130 and an expiration date of July 31. The call option gives the investor the right to purchase 100 shares of AAPL on or before July 31. Assuming AAPL is trading at $135 on July 30, the call option is considered in-the-money and the investor could exercise his right to buy 100 shares of AAPL for $130. Thereafter, the investor could sell his shares of AAPL for $135 per share.

Contrary to call options, forward contracts are binding agreements between two parties to buy or sell an asset at a specific price on a specific date. For example, assume two parties agree to trade 100 troy ounces of gold at $1,100 per troy ounce on Dec. 31. One party who enters into this agreement is obligated to buy 100 troy ounces of gold, while the other party is obligated to sell 100 troy ounces at a price of $1,100 per troy ounce. Unlike a forward contract, the buyer is not obligated to purchase the asset. The holder of the contract could choose not to exercise the option and allow the option to expire worthless.

By the staff at Investopedia.com

Related Articles on OPTIONS