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What Is A Call Option?

Views 13582022.11.09

Key Takeaways

Call options are used by a wide range of investors to achieve different goals within their investment strategies. This guide provides key insights for those looking to incorporate the buying and selling of call options into their investment approach.

What is a Call Option?

Call options are a type of option that see their value increase in direct correlation to a rise in value in the option’s underlying asset. These are the most common kinds of options, giving the owner the ability to lock in the price they’re willing to pay to purchase a specific stock by a predetermined date. Should the stock’s price not reach that rate, the owner of the call option is under no obligation to purchase it.

Understanding Call Options

In order for investors to be able to put call options to work within their investment strategy, it’s important for them to understand how a call option works. As a more advanced tool that can be useful in helping investors to limit their risk and increase their potential profit, call options can play a significant role in a diversified, balanced investment portfolio.

These forms of options are often appealing to investors because of their ability to appreciate relatively quickly should a small move up happen on the stock price in question. For traders who are looking for opportunities to realize profits, call options can create that opportunity.

How do Call Options work?

Call options give the owner the right, without the obligation, to buy a stock at a strike price (the specific price the owner sets) by a specified date (the option’s expiration). In order to secure this right, the call buyer pays a fee, called a premium, to the call seller.

Call options differ from stocks in that they cease to exist after expiration. This means they also run the risk of being worthless if the option isn’t exercised, forming a risk investors need to consider before purchasing them.

A call option is made up of these traits:

Strike price - this is the price at which the investor is willing to purchase the underlying stock

Premium - this is the fee paid for the option from the buyer to the seller

Expiration - this is the date upon which the option expires, settling the call option either with or without a stock purchase

Long vs. Short Call Options

Investors may choose to purchase either a long call option or a short call option. Each strategy has different outcomes, and many investors use a mixture of both in order to achieve varying investment goals across the course of their investment journey.

A long call: speculation or planning ahead

A long call is a secured call option that has an open right to buy shares. This kind of call is often used for speculative purposes, where investors are looking to place a long call ahead of a potential appreciation in stock price.

For many investors, these are useful in planning ahead, using long calls as a way to exercise the right to purchase shares at a predetermined future date.

A short call: boosting income

A short call is an open obligation to sell shares, where the seller of a call has received payment for that call, and in return, must sell shares of the underlying stock at the strike price of the call until the expiration date is reached. Short calls are used to generate income, giving the investor the opportunity to earn a premium.

However, short calls also expose them to the upside risk, with the chance that the stock price in question may climb in value to be higher than the strike price before the expiration date. In this situation, the seller of a call will meet the unlimited risk if the market goes up infinitely.

Uses of Call Options

Call options are generally used by investors to achieve key outcomes such as generating an income or betting on speculation.

Using covered calls for income

Call options can allow investors to generate income via a covered call strategy, where the investor owns the underlying stock while simultaneously writing a call option. This allows the investor to collect the option premium, generating income if the option expires below the strike price. But if the option expires above the strike price, the investor may lose the option premium or lose some potential profits.

Using calls for speculation

Speculative investors can also use call options to gain exposure to a stock for a reduced price. This may return a gain if the stock rises in value, but can also result in a loss of the premium if the call option expires before the underlying stock price has moved above the strike price.

Factors that affect price

A number of factors may affect the price of a call option, including the price of the underlying security, its intrinsic value at its current state (the value the option holds if it were to be executed immediately), its implied volatility and the remaining useful life of the option matching increases.

Example of a Call Option

Let’s take a look at an example of a call option in action. If an investor were to purchase a call for $1 with a strike price of $10, and the stock is worth $12 at expiration, the option is then worth $2 (the stock price minus the strike price). The investor has made a profit of $1 (the option value minus the premium).

If the stock price isn’t above the strike price at the point of expiration, the call is deemed ‘out of the money’, becoming worthless upon expiry. The call seller would keep the premium they received for the call option.

Why would you buy or sell a call option?

Call options are of interest to investors who believe a certain stock is likely to rise in value, giving them one of two ways to consider if the stock will go up.

The other option is for that investor to own the stock directly - however, buying a call option may result in more profit than direct investment in the stock itself. But there're still some potential risks for investors to lose money if the stock price goes down and is much lower than the strike price.

Buying a call option vs. owning the stock

If a stock sees a significant increase in price, a call option offers better profitability than owning the stock. This is because a call buyer’s potential loss is capped to the cost of the premium, while the stock owner’s potential loss is as large as their initial investment (or even more, if they purchased it on a margin).

Of course, owning the stock itself awards the investor the chance to wait indefinitely for continued movements in the stock’s value. Options, by comparison, have an expiry date, which is a disadvantage for traders looking to benefit from long-term trades.

Selling a call option

When it comes to selling a call option, rather than buying one, the payoff structure is reversed.

Investors who are selling calls are expecting the stock itself to remain at its current value, or to decrease in value, hedging their bets in order to profit from the premium without the need to sell the stock itself.

Covered call option

A covered call option involves selling a call option within a hedged strategy, with a trader selling a single all option for every 100 shares of the stock they own. As the call seller owns the underlying stock, potential losses are limited, with the ability to generate income should the stock not rise in value to the strike price by the point of expiration.

Naked call option

A naked call option is the opposite of a covered call option. It’s also referred to as an uncovered call or an unhedged short call. In this strategy, the investor sells a call open without already owning the underlying security, opening themselves up to the risk that the security will rise in value beyond the profit made from the premium. The risk can be unlimited.

How to calculate Call Option payoffs

Before investing in a call option, traders must be familiar with how to calculate their potential payoffs. A call option payoff is defined by the profit or loss made by an option buyer within a trade, with factors such as the strike price, expiration date, premium, and commissions all impacting the potential payoff.

As with any other kind of investment, buying or selling call options come with risks. These include the risk of losing some or all of the value of the premium, or the risk of being ‘called out’ of a long position on a stock, which would lead to a potential loss of upside gains. That’s why it’s so important for investors to understand how to accurately calculate the risk profiles of each call option, as well as know how to effectively calculate call option payoffs.

Payoffs for Call Option buyers

The payoff for a call option buyer is calculated by subtracting the strike price from the spot price. The profit is then calculated by adding the payoff to the premium.

Payoffs for Call Option sellers

Similarly to a payoff for a call option buyer, the payoff for a call option seller is calculated by deducting the spot price from the strike price. The profit is calculated by adding the payoff to the premium.

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