Call Option Explained

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Call Option Definition

What Is a Call Option?

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, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.

Key Takeaways

  • A call is an option contract giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time.
  • The specified price is known as the strike price and the specified time during which a sale is made is its expiration or time to maturity.
  • Call options may be purchased for speculation, or sold for income purposes. They may also be combined for use in spread or combination strategies.

Call Option Basics

The Basics of Call Options

For options on stocks, call options give the holder the right to buy 100 shares of a company at a specific price, known as the strike price, up until a specified date, known as the expiration date.

For example, a single call option contract may give a holder the right to buy 100 shares of Apple stock at $100 up until the expiry date in three months. There are many expiration dates and strike prices for traders to choose from. As the value of Apple stock goes up, the price of the option contract goes up, and vice versa. The call option buyer may hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock or sell the options contract at any point before the expiration date at the market price of the contract at that time.

The market price of the call option is called the premium. It is the price paid for the rights that the call option provides. If at expiry the underlying asset is below the strike price, the call buyer loses the premium paid. This is the maximum loss.

If the underlying’s price is above the strike price at expiry, the profit is the current stock price, minus the strike price and the premium. This is then multiplied by how many shares the option buyer controls.

For example, if Apple is trading at $110 at expiry, the strike price is $100, and the options cost the buyer $2, the profit is $110 – ($100 +$2) = $8. If the buyer bought one contract that equates to $800 ($8 x 100 shares), or $1,600 if they bought two contracts ($8 x 200). If at expiry Apple is below $100, then the option buyer loses $200 ($2 x 100 shares) for each contract they bought.

Important

Call options are often used for three primary purposes. These are income generation, speculation, and tax management.

Covered Calls for Income

Some investors use call options to generate income through a covered call strategy. This strategy involves owning an underlying stock while at the same time writing a call option, or giving someone else the right to buy your stock. The investor collects the option premium and hopes the option expires worthless (below strike price). This strategy generates additional income for the investor but can also limit profit potential if the underlying stock price rises sharply.

Covered calls work because if the stock rises above the strike price, the option buyer will exercise their right to buy the stock at the lower strike price. This means the option writer doesn’t profit on the stock’s movement above the strike price. The options writer’s maximum profit on the option is the premium received.

Using Options for Speculation

Options contracts give buyers the opportunity to obtain significant exposure to a stock for a relatively small price. Used in isolation, they can provide significant gains if a stock rises. But they can also result in a 100% loss of premium, if the call option expires worthless due to the underlying stock price failing to move above the strike price. The benefit of buying call options is that risk is always capped at the premium paid for the option.

Investors may also buy and sell different call options simultaneously, creating a call spread. These will cap both the potential profit and loss from the strategy, but are more cost-effective in some cases than a single call option since the premium collected from one option’s sale offsets the premium paid for the other.

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Using Options for Tax Management

Investors sometimes use options to change portfolio allocations without actually buying or selling the underlying security.

For example, an investor may own 100 shares of XYZ stock and may be liable for a large unrealized capital gain. Not wanting to trigger a taxable event, shareholders may use options to reduce the exposure to the underlying security without actually selling it. While gains from call and put options are also taxable, their treatment by the IRS is more complex because of the multiple types and varieties of options. In the case above, the only cost to the shareholder for engaging in this strategy is the cost of the options contract itself.

Real World Example of a Call Option

Suppose that Microsoft shares are trading at $108 per share. You own 100 shares of the stock and want to generate an income above and beyond the stock’s dividend. You also believe that shares are unlikely to rise above $115.00 per share over the next month.

You take a look at the call options for the following month and see that there’s a 115.00 call trading at $0.37 per contract. So, you sell one call option and collect the $37 premium ($0.37 x 100 shares), representing a roughly four percent annualized income.

If the stock rises above $115.00, the option buyer will exercise the option and you will have to deliver the 100 shares of stock at $115.00 per share. You still generated a profit of $7.00 per share, but you will have missed out on any upside above $115.00. If the stock doesn’t rise above $115.00, you keep the shares and the $37 in premium income.

Call Option

Definition:
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Call Options

Call buying is the simplest way of trading call options. Novice traders often start off trading options by buying calls, not only because of its simplicity but also due to the large ROI generated from successful trades.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares.

Say you were spot on and the price of XYZ stock rallies to $50 after the company reported strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, your call buying strategy will net you a profit of $800.

Let us take a look at how we obtain this figure.

If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000.

Since you had paid $200 to purchase the call option, your net profit for the entire trade is $800. It is also interesting to note that in this scenario, the call buying strategy’s ROI of 400% is very much higher than the 25% ROI achieved if you were to purchase the stock itself.

This strategy of trading call options is known as the long call strategy. See our long call strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Selling Call Options

Instead of purchasing call options, one can also sell (write) them for a profit. Call option writers, also known as sellers, sell call options with the hope that they expire worthless so that they can pocket the premiums. Selling calls, or short call, involves more risk but can also be very profitable when done properly. One can sell covered calls or naked (uncovered) calls.

Covered Calls

The short call is covered if the call option writer owns the obligated quantity of the underlying security. The covered call is a popular option strategy that enables the stockowner to generate additional income from their stock holdings thru periodic selling of call options. See our covered call strategy article for more details.

Naked (Uncovered) Calls

When the option trader write calls without owning the obligated holding of the underlying security, he is shorting the calls naked. Naked short selling of calls is a highly risky option strategy and is not recommended for the novice trader. See our naked call article to learn more about this strategy.

Call Spreads

A call spread is an options strategy in which equal number of call option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Call spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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How a Call Option Trade Works

You can think of a call option as a bet that the underlying asset is going to rise in value. The following example illustrates how a call option trade works.

Assume that you think XYZ stock in the above figure is going to trade above $30 per share by the expiration date, the third Friday of the month. So you buy a $30 call option for $2, with a value of $200, plus commission, plus any other required fees.

If you’re right, and XYZ is up to $35 per share by the expiration date, you can exercise your option, buy 100 shares of XYZ at $30, which costs you $3,000, and then sell it on the open market at $35, realizing a gain of $500 minus your initial $200 premium, commissions, and other fees.

In this case, your option is in the money, because the strike price is less than the market price of the underlying asset.

When you, the option holder, put in your order, the dealer searches for someone on the other side of the trade, in other words the option writer, with the same class and strike price of the option. The writer is then assigned the trade and must sell his shares to you, if you exercise the option.

So, a call assignment requires the writer, the trader who sold the call option to you, to sell his stock to you. A put assignment, on the other hand, requires the person who sold you the put on the other side of the trade (again, the put writer) to buy the stock from you, the put holder.

You have two other possibilities: You can hold the stock, knowing that you have a $5 cushion, because you bought it at a discount, or you can sell the option back to the market, hopefully at a profit.

According to the CBOE, most options never are exercised. Instead, most traders sell the option back to the market.

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