What is a Call Option?
A call option is a contract that gives the option holder the right to purchase securities at a specified price on or before the option’s maturity date. These securities could include stocks, bonds, or other commodities.
Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity, or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer profits when the underlying asset increases in price.
A call option may be contrasted with a put option, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.
The following components comprise the major traits of an option:
- Strike price: The price at which you can buy the underlying stock
- Premium: The price of the option, for either buyer or seller
- Expiration: When the option expires and is settled
One option is called a contract, and each contract represents 100 shares of the underlying stock. Exchanges quote options prices in terms of the per-share price, not the total price you must pay to own the contract. For example, an option may be quoted at $0.75 on the exchange. So to purchase one contract it will cost (100 shares * 1 contract * $0.75), or $75.
How a call option works
Call options are in the money when the stock price is above the strike price at expiration. The call owner can exercise the option, putting up cash to buy the stock at the strike price. Or the owner can simply sell the option at its fair market value to another buyer.
A call owner profits when the premium paid is less than the difference between the stock price and the strike price. For example, imagine a trader bought a call for $0.50 with a strike price of $20, and the stock is $23. The option is worth $3 and the trader has made a profit of $2.50.
If the stock price is below the strike price at expiration, then the call is out of the money and expires worthless. The call seller keeps any premium received for the option.
Why buy a call option?
The main reason people buy call options is to generate a profit on a stock they’re bullish on. Other factors include the following:
- Low risk. Since you risk losing only the premium when you go long on a call option, this strategy offers a low-risk way to speculate on the underlying stock.
- Leverage. With low risk also comes leverage. For the price of the premium, you can invest in 100 shares of stock for pennies on the dollar.
- Hedging/stop loss. Buying a call option is a way to hedge your short position on the underlying stock. You can minimize the downside if the stock suddenly shoots up in value. This effectively turns your call option into a stop-loss instrument.
- Portfolio/tax management. You can use options to change portfolio allocations without actually buying or selling the underlying stock. This could be part of a strategy to reduce your exposure to a stock you own with a large unrealized capital gain. Although gains from options are taxable, nothing is reported until the option is exercised, sold, or expires.
Why sell a call option?
If you own a call option there are three things you can do with it. Let it “expire worthless” and lose the premium you paid (although that’s all you lose); exercise your option to buy the underlying asset so you can sell it for a profit; or sell the option before it expires, also to turn a profit.
Here are some of the reasons you may want to sell your call option:
- Make a profit. Over time, the underlying asset may rise in price which will, in turn, raise the premium (fee the seller would receive). You may choose to sell your option and pocket the profit from the increased fee you would receive.
- Avoid loss. If the underlying asset remains steady or declines, you may decide to sell to recover at least part of your premium before the option expires worthless.
- Avoid paying commissions. Even if you believe the stock will expire in the money the premium you receive for selling the option instead of exercising your option will let you avoid paying commissions that could negatively affect your profit.
- Avoid risk of spillage. Spillage happens when you exercise your option, try to sell the underlying asset on the market, and don’t get what you expect.
Another way to sell a call option is to write your own. There are two main types of written call options, naked and covered.
Naked call option. This is when you write (create) a call option for underlying assets you don’t own. In this case, you’d write an option for a stock you think will not increase in price before the expiration date you set. A buyer thinks otherwise and pays you a premium for the contract you wrote. If the option expires worthless, you keep the entire premium as your profit.
If the value of the asset increases and you have to sell the buyer 100 shares at the strike price, and you lose the difference between the strike price and the amount you have to pay for the shares minus the premium.
Covered call option. A covered option is when you write a call option for an asset you already own. Your motivation is the same: You believe your asset will stay the same or decline by the expiration date. You sell the option to get the premium (fee paid by the buyer).
If the asset performs as you expected, you keep the premium and that helps to offset the loss in value of the asset you own. If the asset rises in value, you’ll need to hand it over to the buyer for the strike price. You’ll lose the gain you would have had if you still owned the asset, minus the premium you received.
Why call options can make sense
Call options are popular because they can allow investors to achieve different means. One lure for investors wanting to speculate is that they can magnify the effects of stock movements, as the table above indicates. But options have many other uses, such as:
Limit risk-taking, while generating a capital gain. Options often are seen as risky, but they can also be used to limit risk or hedge a position. For example, an investor looking to profit from the rise of XYZ stock could buy just one call contract and limit the total downside to $500, whereas for a similar gain a stockholder’s much larger investment would be wholly at risk. Both strategies have a similar payoff, but the call limits potential losses.
Generate income from the premium. Investors can sell call options to generate income, and this can be a reasonable approach when done in moderation, such as through a safe trading strategy like covered calls. Especially in a flat or slightly down market, where the stock is not likely to be called, it can be an attractive prospect to generate incremental returns.
Realize more attractive selling prices for their stocks. Some investors use call options to achieve better selling prices on their stocks. They can sell calls on a stock they’d like to divest that is too cheap at the current price. If the price rises above the call’s strike, they can sell the stock and take the premium as a bonus on their sale. If the stock remains below the strike, they can keep the premium and try the strategy again.