What Is a Call Option?
A call option is a contract between a buyer and seller. It gives the option holder the opportunity to purchase a specific stock, bond, or commodity at a defined price up until a set expiration date. The defined price is referred to as the strike price.
As a derivative instrument, call options’ prices are derived from the price of another instrument (such as stocks or commodities).
Calls vs. Puts
The opposite of calls, puts are options to sell the underlying asset at the strike price with an expiration date on the contract. Like calls, put options are derivative investments.
To keep the definitions of calls and puts straight, think of them like this: You “call” something to you (e.g. buy stock, buy call options) and you “put” it away (e.g. sell the stock, sell put options).
How Does a Call Option Work?
A call option is purchased through a broker who receives the premium as payment for their service. Call option contracts for stocks are commonly sold in blocks of 100 shares.
The contract purchaser may hold onto the call option until its expiration date, exercise the option and buy the asset before the expiration date, or sell the option contract to someone else.
A call option will be exercised only if the market price of the underlying asset rises above the strike price. In such a case, the option holder would pay the strike price and own more highly-valued shares.
An Example of a Call Option in Action
An investor looking over technology stocks notices that Company ABC’s stock is currently trading at $100 per share. Over the past three years, the company announced its annual product lineup on the last Friday in June. The investor also observes that such announcements have led to a surge in the stock price.
With this pattern in mind, the investor purchases a call option for 100 shares from Company ABC at a strike price of $110 and a June 30 expiration date. Given her knowledge of past company announcements and how they’ve affected the company’s shares, she’s betting that the stock price will rise above $110 before June 30.
Sure enough, on June 25, the company announces exciting new software arriving at retail outlets worldwide before October 1. With this news, Company ABC’s stock price rises rapidly to $120 per share.
The investor may now exercise her call option and purchase the 100 shares of Company ABC’s stock for the strike price of $110 per share. After paying a premium of $3 per share – and selling her new acquisition immediately – she nets $7 per share profit for a total of $700.
Alternatively, she can hold onto Company ABC’s stock and enjoy any potential gains the stock makes over time.
For an in-depth look at a call options strategy, see: Managing Currency Risks with Options
What Is Maximum Loss?
What happens if the asset is below the strike price at the expiration date? If the asset’s value is less than the strike price on the expiration date, the call option buyer would choose to not exercise the option (that is, to not buy the asset at all). This limits the buyer’s losses to only the amount paid for the premium, the cost of buying the option. This is called the “maximum loss.” Knowing the maximum loss ahead of time enables investors to understand the risks and potential rewards of utilizing call options.
Why Call Options Are Used
Investors use call options for several reasons, including:
As with most investments, profit is the paramount reason for why call options are used. If an investor believes the stock price will rise above the strike price before the option’s expiration date, there’s the potential for substantial profit. In some cases – particularly during periods of high volatility in the stock market – an options contract costing hundreds of dollars could result in thousands of dollars in profit.
Call options can also be used to hedge risk. A hedging strategy uses losses from one position to partially or fully offset by gains in another position. By taking both put and call options on an asset, the risk of significant loss is lessened.
Options’ Financial Risk
Options can be risky investments, but the risk is limited to the premium price, which is much smaller than the price of the asset. Buying the stock outright opens the risk for losing more money than buying call options does, but options are considered riskier as they have much higher potential percentage losses.
For example, assume that an investor purchases 100 shares of Company ABC stock for $100 per share. He will have spent $10,000 to own 100 shares of stock. If the stock’s price falls to $50 per share, his 100 shares are now worth $5,000. He has a loss of $5,000, and still owns $5,000 of stock.
If, instead of buying the 100 shares, suppose he had purchased a call option contract and paid a premium of $300 for the contract ($3 per share) with a strike price of $110. If, at expiration, the stock price has fallen below the strike price, to $50 per share, he would have lost only the premium price, which was much smaller than the shareholder’s initial investment. In that sense, the call option contract limited his risk. However, looking at it another way, the call option investor has lost 100% of his investment, whereas the stock investor has lost only 50% of his investment.
Risks and Cautions
Call options are one of several derivative investments that enable an investor to diversify their holdings and manage risk.
Call options are considered a speculative investment strategy and should be employed only by experienced investors who thoroughly understand how they work (and can accept associated risks).
Ask an Expert
Can a Casual Investor Make Money with Call Options?
Barron's states that 90% of options traders lose money. While this exact percentage is a bit uncertain, trading call options isn’t right for everyone and can be considered a form of market timing (albeit one with a longer view than those trying to time their stock buys and sells). Remember: Any market timing is difficult to do with any degree of accuracy.
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