Definition and Examples of a Call Option
A call option is a contract between two parties that gives the call’s buyer the right to buy the underlying security, commodity, or contract. Also defined in the contract are the terms of this transaction—the defined price at which it would take place (strike price) and the time period for its execution (exercise date). The buyer pays a small fee, or premium for this right. Call option contracts are sold in 100-share lots. After the exercise date, the option ceases to exist.
The buyer of a call option is not obligated to exercise the call and execute the purchase. The buyer does still pay the premium even though the call was not executed. The seller, on the other hand, is obligated to sell the security at the specified price upon the buyer’s request.
How Call Options Work
You can buy or sell call options depending on your expectations for the underlying security’s price. Depending on your trading strategy, you can choose to exercise the option, choose to let it expire or sell the option contract.
It makes sense to purchase a call option if you believe the security could rise in value before the exercise date.
For example, this is what a call option looks like: XYZ December 80 Call $1.20
This means it is a call option contract for the shares of XYZ stock, with an expiration date of December, with a strike price of $80 and a premium of $1.20.
Generally, traditional options contracts expire on the third Friday of each month. Some options contracts specify other expiration dates.
So how do you determine a call option buyer’s profit? If you're exercising the option, start with the price of the underlying security; subtract the strike price, the option's premium, and any transactional fees; and you arrive at your option's profit, or the intrinsic value. The strike price ultimately determines whether an option has intrinsic value. While you may also make a profitable trade by selling the option contract, for the purpose of this article, we will consider only call options where the buyer either exercises or lets the options expire.
For example, say Sam owns 100 shares of XYZ, valued at $70 per share. If Mary believes shares of that stock are going to increase in value, then she may purchase a call option to buy those shares at a strike price of $80. If the share price reaches $90 before the exercise date and Mary exercises the option, she realizes a $10 per share profit. This creates a total gain of $1,000 (100 shares x $10 profit per share).
Keep in mind that Mary paid Sam $1.20 per share premium price, for a total premium of $120. That decreases the net gain for Mary to $880 ($1,000 - $120). Transaction fees may reduce the net gain further.
When Call Options Make or Lose Money
In-the-money calls: When the strike price is below the stock price As explained in the example above, the call option buyer's profit is gain in stock price minus the premium and transaction fees.
At-the-money calls: When the strike price equals the stock price. A call option buyer may choose not to exercise their right to buy the shares because net of the premium buying the transaction would yield no gain.
Out-of-the money calls: When the stock price falls below the strike price, making the option exercise futile as the shares are more expensive to buy.
If the price doesn't rise above the strike price, the buyer won't exercise the option. The only loss is the premium. That’s true even if the stock plummets to zero.
If you believe shares of a stock are going to increase, why would you buy a call option instead of simply purchasing shares of that stock? One reason is to limit your exposure to loss. Say you purchase a call option for $300 (100 shares at $3 per share premium) and the business goes bankrupt that week. You won’t exercise the option and your loss is limited to $300.
Selling a Call Option
A seller of a call option is called the writer. A person sells a call option if they are losing money or neutral on the asset. Remember, the seller receives the premium whether the call option is exercised or not. There are two ways to sell call options.
Naked Call Option
A naked call option occurs when you sell a call option without owning the underlying asset. It's a perilous decision. If the buyer exercises the option, you have to buy the asset at the market price to satisfy the order. If the price is higher than the strike price, you will lose the difference minus the fee you paid.
There is no limit to your potential loss on naked calls since there's no limit on how high an asset's price can rise. You've got to hope that the fee you charge is more than enough to pay for your risk.
Most writers of naked call options are large corporations that can diversify the risk. Their profits from many premiums on the options they guess correctly outweigh the occasional losses on an option that goes against them. These corporations have analysts with computer programs that figure all this out for them.
Covered Call Option
If you are thinking of selling an asset you already own, you might want to sell a covered call option on it instead. You make risk-free money from the premium you charge for the option. You also make money when the strike price is higher than the amount you originally paid, and the buyer exercises the option. It's called a covered call because the option is "covered" by the asset.
The risk of a covered call option is missing out on gains if the share price jumps. You cannot sell your shares at that price and keep the profit. Instead, you must sell the agreed amount of shares to the call option holder at the strike price. You will keep the premium, but the call option holder reaps the net profit from the share price increase.
Many writers of covered calls enjoy the risk-free income from the premiums. If you own significant assets, and you need cash now, a covered call may be a good option.
Call vs. Put Options
An investor in a put option is betting the share price will drop below the strike price. A holder of a put option has the right to sell the security at a specific price at any time within the exercise date.
A put option is in the money if the underlying security’s price is less than the strike price. If the security’s price rises beyond the strike price, the put becomes out-of-the money.
The intrinsic value of a put option is the difference between the current price of the underlying security and the option’s strike price. A holder of a put option will not exercise the put if the price does not drop below the strike price. Here again, the seller of a put option keeps the premium whether the option is exercised or not.
One advantage of call and put options is that investors can enter into contracts with limited capital, as the initial investment is only the price of the premium. Options trading strategies can be risky and are not for everyone.
The chart below compares call and put options.
|Call Option||Put Option|
|Buyer has the right, but not the obligation to:||Purchase agreed-upon underlying security at the strike price by the expiration date.||Sell agreed-upon underlying security at the strike price by the expiration date.|
|The contract is valuable or in-the-money when:||The price of the underlying security is greater than the strike price.||The price of the underlying security is lower than the strike price.|
|The contract loses value or is out-of-the money when:||The price of the underlying security is lower than the strike price||The price of the underlying security is greater than the strike price.|
- A call option gives an investor the right to buy an underlying asset (often shares of stock) at a predetermined price (strike price) within a certain amount of time.
- Typically, investing in call options makes sense if you expect the price of the underlying asset to rise.
- The buyer of a call option pays a premium for the right to purchase the shares. If the option is not exercised, the buyer’s loss is limited to the premium.
- Options are a means of hedging risk for a buyer and a means of generating income for option sellers.