Call Option vs. Forward Contract: An Overview
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.
Key Takeaways
- A call option gives the buyer the right (not the obligation) to buy an asset at a set price on or before a set date.
- A forward contract is an obligation to buy or sell an asset.
- The big difference between a call option and forward contract is that forwards are obligatory.
- Forwards are also highly customizable, allowing for a customized date and price.
Call Option
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 their option or if the option expires in the money.
For example, assume an investor purchases one call option contract on Apple (AAPL) with a strike price of $300 and an expiration date of Sept. 18, 2020. The call option gives the investor the right to purchase 100 shares of Apple on or before Sept. 18. If AAPL trades at $300 on or before Sept. 18 it's considered in the money (ITM), and the investor could exercise their right to buy 100 shares of Apple for $300 each.
Forward Contract
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. Forwards do not trade on a centralized exchange, instead of trading over-the-counter (OTC). These instruments aren't often used or available for retail investors. Forwards are also different than futures contracts, which does trade on an exchange.
For example, assume two parties agree to trade 100 troy ounces of gold at $2,000 per troy ounce on Dec. 31, 2020. 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 $2,000 per troy ounce.
Unlike a call option, the buyer is obligated to purchase the asset. The holder of the contract cannot allow the option to expire worthlessly, as with a call option. A forward contract can be settled on a cash or delivery basis. The benefit of a forward contract is that these contracts can be customized based on the amount and delivery date.
Key Differences
A call option provides the right but not the obligation to buy or sell a security. A forward contract is an obligation—i.e. there is no choice. Call options can be purchased on various securities, such as stocks and bonds, as well as commodities. Meanwhile, forward contracts are reserved for commodities, such as oil and precious metals.
