Call Options and Reasons to Buy or Sell them

Trader exercising a call option.
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A call option is an agreement that gives you the right to buy a stock, bond, commodity, or other security at a specific price up to a specific date. The agreed-upon price is called the strike price. The date is called the exercise date.  You pay a small fee, or premium, for this right, which is the contract. Call option contracts are sold in 100-share lots. 

A call option, or call, is a derivative. Its value is derived from the price of an underlying real asset. In this case, the asset is the stock, bond, or other security. 

Why Buy a Call Option

Why would you buy a call option? Only if you believe the security will rise in value before the exercise date. If that happens, you'll exercise the option. You'll buy the security at the strike price and then immediately sell it at the higher market price. If you feel bullish, you might also wait to see if the price goes even higher. Buyers of call options are called holders.

Your profit equals the security proceeds, minus the strike price, the premium for the call option, and any transactional fees. That's called being in the money. The profit is called the option's intrinsic value.

If the price doesn't rise above the strike price, you won't exercise the option. Your only loss is the premium. That's true even if the stock plummets to zero.

Why wouldn't you just buy the security instead? Buying a call option gives you more leverage. If the price rises, you can make a lot more money than if you bought the security instead. Even better, you only lose a fixed amount if the price drops. As a result, you can gain a high return for a low investment.

The other advantage is that you can sell the option itself if the price rises. That means you've made money without ever having to pay for the security. 

Why Sell a Call Option

You would sell a call option if you believe the asset price will drop. If it drops below the strike price, you keep the premium. A seller of a call option is called the writer. There are two ways to sell call options.

Naked Call Option: A naked call option is when you sell a call option without owning the underlying asset. It's perilous. 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 option, you'll lose the difference minus the fee you paid. There is no limit to your potential loss 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. They 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 biggest only downside risk of a covered call is that you'll miss out if the price skyrockets. You can't sell it at that price. Instead, you've got to hold onto it. You can only sell it to the option holder at the strike price.

Many writers of covered calls enjoy the risk-free income from the premiums. If you sell enough of these calls, this can add up. They also like getting the money right up front. If you own significant assets, and you need cash now, a covered call may be right for you.

Call Versus Put Option

The opposite of a call option is a put option. That gives investors the right to sell the security at a specific price at any time up to a specific date.