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- A call option is a contract that gives you the right but not the obligation to buy a specified asset at a set price on or before a specified date.
- The cost of buying a call option is called the premium and it acts like insurance against major loss.
- This important trait of call options lets you hedge your bet. The option versus obligation to buy the asset lets you wait and see.
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The simplest way to make money in the market is to buy a stock or other asset, wait for it to go up in price, and then sell it for a profit. Alternatively, you could buy an option, which doesn't require you to buy the actual stock. That's because an option is a contract that lets you decide whether to buy the stock now, buy it later, or not at all.
"The key to trading options safely is to be long – that is to buy options – rather than selling options," says Robert R. Johnson, Professor of Finance, Heider College of Business at Creighton University. "When an investor buys an option the most they can lose is what they paid for the option. When someone sells an option they have a virtually unlimited liability if the price of the asset moves against them."
Here we discuss one specific type of option – the call option – what it is, how it works, why you might want to buy or sell it, and how a call option makes money.
What is a call option?
A call option is a financial contract that, for a fee, gives you the right but not the obligation to purchase a specific stock at a set price on or before a predetermined date.
There are two types of options: call options and put options. Put options gives you the right but not the obligation to sell a stock at a set (strike) price on or before the expiration date. If you think a stock is going to go up before the expiration date, a call option lets you profit from the rise in price. If you think the stock is going to go down, a put option lets you profit from the fall.
Call options use special terms to refer to various components and actions:
- Contract. A call option is a contract between you (buyer) and the seller (writer) of the option contract. Call option contracts are typically for 100 shares of the underlying stock named in the contract.
- Premium. This is the fee you pay to purchase a call option contract. It's a per-share amount you pay, similar to an insurance premium. The premium protects you from losing a large amount of money if things don't go the way you expect.
- Expiration date. This is the last day the option contract is valid and is set by the writer (seller) of the options contract. If you don't buy the stock by then, the option expires worthless and you lose the premium you paid.
- Strike price. The strike price is the price the seller agrees to sell a single share of stock for on or anytime before the expiration date.
- In the money. When the current price of the underlying stock is above the strike price, the contact is said to be "in the money.
- Out of the money. Conversely when the current price of the underlying asset is below the strike price, the contract is said to be "out of the money."
- At the money. As you might expect, this describes a contract in which the underlying stock price and the strike price are the same.
- Exercise option. This is what you do if you decide to buy the underlying stock at the strike price on or before the expiration date.
How call options work
Owning a call option contract is not the same as owning the underlying stock. A call option contract gives you the right to buy 100 shares of the underlying stock for the strike price for a predetermined period of time until the expiration date of the contract.
This important trait of call options lets you hedge your bet. The option versus obligation to buy the asset lets you wait and see.
Things that may impact your decision to buy a call option could include the strike price; Is it too high? What about the premium? Would you be paying too much for your insurance? And what about the expiration date? Is it too far into the future - or too soon?
If your asset appreciates in value you can:
- Exercise your option, buy the asset, sell it, and keep the profit.
- Sell the option contract for its new higher value and keep the profit (premium).
If the asset stays the same or goes down in value you can:
- Sell the option contract and recover at least part of the premium you paid.
- Let the option expire worthless and lose the entire premium.
Fortunately, there are many options contracts available. Chances are you can find one that aligns with your own analysis of the stock or asset in question.
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.
When it comes to selling call options, however, Alexander Voigt, Founder and CEO of daytradingz, offers the following caveats: "Investors are often tempted to trade the so-called naked options because it appears attractive to collect the options premium. However, selling options without limiting the risk by hedging the options trade involves unlimited risk."
"Unforeseen overnight price gaps caused by news catalysts like earnings announcements involve the highest risk," he continues. "In addition, investors must be aware that the buyer of the call option has the right to demand the underlying stock at the strike price from the option seller prior to expiration."
The financial takeaway
A call option is a contract to buy an underlying asset - not the asset itself. The contract gives you the right, but not the obligation, to purchase the underlying asset at a set price before a set date. For this right, you'd pay a fee or premium, similar to an insurance premium. This premium protects you in case the underlying asset doesn't increase in value.
While it may all sound simple, options can be complicated. Buying a call option is considered a good entry point for anyone interested in beginning to trade options, but as with any type of investing, caution is advised. As always, seek the advice of a trusted financial advisor before starting any new type of investment.