What is a Call Option?

Posted on Friday, September 21st, 2018 MarketBeat Staff

In life, one of the easiest things to do is to spend other people’s money. It’s a cute phrase, but in the world of investing, while it may not be easy to spend other people’s money, it can be profitable. However, it does require that investors become knowledgeable about an area of investing that is thought by some to be taboo…options trading.

Options trading sometimes gets a bad reputation, but it’s really nothing more than a strategy in which an investor gives themselves the “option” to take a particular buying or selling action for a fee that is paid by the owner of the option and collected by the other party. One of the simplest strategies of options trading – and one that typically carries minimal risk – is the call option.

This article will go into detail about what a call option is and why an investor may choose to use one. When you’re finished reading, you should have a better understanding of how you can put this strategy to work in your portfolio.

What is a call option?

A call option is a financial contract between a buyer and a seller. The specific details of the call option will be unique to every transaction, but the concept is simple. As the owner of the call option, an investor is buying the right, but not the obligation, to purchase a specific number of shares of a company’s stock at an agreed upon price. The seller is obligated to sell the shares to the buyer at the agreed upon price on the expiration date should the buyer decide to “call” the option.

If the stock price climbs above the agreed upon price, the buyer of the option may exercise his right. At this point, the seller must sell him the shares for the agreed upon price. The buyer of the shares can then trade his new shares at market value and collect a profit.

If the stock price does not climb above the agreed upon price, the buyer of the option can simply choose to let the option expire. In this case, the buyer of the option is only out the money he paid to purchase the option.

Key terms to help better understand call options

The description above was an attempt to explain a call option without using a lot of the investor jargon that can sometimes muddy the water. But when you get in front of a broker or other financial professional, they will probably call things by their proper name. So here are some of the terms you need to understand.

Strike price – this is the target price that a buyer sets as the minimum the stock has to rise to for them to consider picking up the option they purchased.

Expiration date– the last date the option can be left open. On or before this date, the buyer of the option must “call” the option otherwise the option is allowed to expire. The expiration date is fixed as the 3rdFriday in the month that the option is expiring.

Premium – this is another word for the cost of the contract. Think of it as a transaction fee when you buy tickets for some event online. The price of the premium is set based on the value of the stock. As the stock price rises, the premium goes up. The important thing to remember about a premium is that for the buyer of the option, this is the only capital that they are truly putting at risk in the event they decide not to exercise (or "call" the option).

In the money – a term used to describe a call option that would be worth more than $0 if sold on the open market.

At the money– a term used to describe a call option where the market price of the stock is the same as the strike price

Although this is not a term, it’s also important to know that one call option contract covers 100 shares of the stock.

What is required to transact a call option?

Every transaction requires a buyer and a seller. So, in this case, a prospective buyer of a stock needs a seller. The buyer also needs to ensure that he has enough funds in his brokerage account to cover the cost of buying the option should he desire to do so plus the premium cost (along with any commissions he will have to pay on the trade).

Types of call options

The most basic form of a call option is known as a buying call option. This is where the buyer initiates the transaction. At any given moment a stock may have many different options contracts available with different expiration dates and different strike prices. So a buyer simply selects the call option that he desires and purchases it from an options broker.

There are also selling call options. Call options are always written by the seller. The seller writes the option in the hopes that the options will expire worthless and they will make a profit from the premium. However, there are two types of selling call options in which the seller forecasts the price of the stock to go up beyond the strike price and tries to make a profit above and beyond the premium. In a covered call, the seller of the call option owns shares in the stock that he is selling the option on. In a naked call, the seller does not own the shares. Both of these selling call options will be described later.

How buying a call option works

Now that we’ve gone over the terms, let’s put it all together in an example.

An investor reviews Intel’s latest earnings report and decides their stock is undervalued. He purchases a call option in July with a strike price of $40 and an expiration date for September 21. As the buyer of the option, the investor owns the right to purchase 100 shares of Intel stock at a price of $40 on September 21. The buyer, of course, will only execute or “call” the option if the stock price is actually above $40 on September 21. If the stock is $40 or below, there would be no intrinsic value to the option and the investor would let it expire. In this case, let’s assume the investor paid a premium of $2 per share for the contract. The investor would only lose his $200 investment ($2 x 100).

But let’s say the investor was right and the price of Intel’s stock surged to $45. In this case, he would call the option and purchase 100 shares of Intel stock for $40. His total investment is now $4,200 (the purchase of the shares plus the premium) not including any commission fees. In order to profit from his stock purchase, the buyer will now sell his 100 shares at market price. This will allow him to pocket a profit of $300.

How selling call options work

Selling call options entail more risk than buying call options and are not for the novice investor and are best left to be covered in detail in a different article. However, here is a basic overview. In a selling call option, the seller is trying to write a call option in such a way as to make a profit off of shares they already own. In the worst case, they hope the contract expires worthless. This would allow them to make money off the premium.

There are two types of selling call options: the covered call and the naked call

In the covered call, the seller owns the quantity of stock they are obligated to sell should the option be called. That is where the name “covered call” comes from. Think of it as having collateral for a loan. In this case, an investor buys a stock that is valued at $50 but anticipates that it is undervalued. They may write a call for $55 with the hopes of attracting a buyer. If the buyer agrees to buy the call option at $55 and the stock continues to go up to $57, the seller will make a profit of $200 after selling their shares to give to the buyer ($5,700 - $5,500 = $200) plus they can keep the premium from the buyer meaning they have pocketed a $400 profit. The buyer in this example would receive a $200 profit, but would effectively break even since they would still be out the $200 premium.

A naked covered call works the same as a covered call only the seller of the call option does not own the stock that they are writing the option for. In this way, they are borrowing money through a margin account that they are anticipating being able to cover with profit to spare. Any option trading that is being done with leveraged money entails a high degree of risk and will probably not suit the average investor's risk tolerance.

Why do investors use call options?

There are two primary reasons investors will use call options. One is to speculate and the other is as a hedge against risk. At the most basic level, a call option allows an investor to speculate in stocks without actually owning them. Any time an investor purchases a stock they are acting on a speculation they have that a stock is going to move in a specific direction. But no matter how confident an investor might be that a stock is going to increase in value, there are no guarantees. That’s where a call option can be useful.

For example, you may decide to purchase a call option on Apple because they are coming out with a new phone and you think the price will rise above its current price of approximately $213. If you have the ability to spend $21,300 to buy 100 shares, you can do that and if it rises to $220, you’ll be set for a nice gain. But you read something about a supplier issue that might delay the launch, you’re pretty sure it won’t be an issue, but you’d rather not take a chance of spending your own money on a launch that may fizzle. By purchasing a call option for 100 shares of Apple stock, you are only risking the cost of the premium which we’ll put at $2 (it may be a bit higher than $2 because of the stock’s market value). In any case, if the launch fizzles, you’ve only put $200 at risk. However, if you purchased the stock outright and the shares that were worth $213 drop to $209, you’ve lost $400 and your potential future risk is hypothetically limitless. In this case, buying a call option can help minimize your downside risk.

As you can also see from this example, a call option provides a hedge against unforeseen events. Let’s say you purchased the call option and a week before the contract expires, Apple announces a huge recall on iPhones. You’ll be glad you’ll only be out the premium for an expiring contract.

The bottom line on call options

A call option is one of the most basic examples of options trading and it’s highly recommended for any investor as a way to develop their trading skills. However, when the average investor hears the words call options, it may conjure up images of unscrupulous brokers preying upon ignorant investors, or it may seem too hard to do. In fact, call options particular a buying call option is actually a very basic form of options trading that can be an effective way for investors to speculate on stocks they may want to buy while minimizing the risk to their capital. In a way, it's a step beyond paper trading. You're putting up some money, but you still have the option to let the trade expire. You don't have to take the loss, other than the premium.

You can purchase a call option through an options broker. The higher the market value of the stock, the higher the premium will be to purchase the call option. However, once you’ve purchased it, that’s where your downside risk is capped. More experienced investors may want to try selling call options. In this case, they write a call option on a stock they foresee as moving well beyond its current price and try to capture a profit by putting a strike price somewhere in the middle of where they bought it and where they see it going.

 

 

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