What Is a Call Option?
A call option is a contract that gives the buyer the right, but not the obligation, to buy an underlying asset (e.g., a stock) at a specified price, called the strike price, before a specified date. On the flip side, the seller of the call option is required to sell the asset if the buyer chooses to exercise the option.
Call options are a type of derivative, a broader category of financial trades whose value is derived from the performance of an underlying asset. These assets may be stocks, indices, commodities, or even cryptocurrencies.
Factors of a Call Option
- Underlying Asset — The security or commodity that the option is based on.
- Strike Price — The price at which the purchaser can buy the underlying asset.
- Premium — The price the buyer pays to purchase the option.
- Final Date — The last day for exercising the option.
- Contract Size — The amount of the underlying asset represented by the option, which is usually 100 shares of stock for stock options.
An Example from the Real World
For example, let’s say you think the stock price of Company XYZ, currently valued at $50, is going to increase over the next month. You buy a call option with a strike price of $55 at a premium of $2 per share. If the stock price goes to $60, you can use your option, buying at $55 and selling at $60 making a $3 per share profit ($60 - $55 - $2 premium). Alternatively, if the stock remains below $55, you simply let the option expire, losing nothing more than the premium paid.
How Do Call Options Work?
A buyer who believes that the price of the underlying asset will increase can buy call options, which allow the buyer to purchase an asset at a specified price within a specified time frame. Here’s how the process works:
- The Buyer Pays a Premium: The buyer pays for the call option price in advance. This premium takes into account the price you pay for the option, but also compensates the seller for the risk they bear.
- Price Moves of the Underlying Asset: The value of a call option increases when underlying security price increases. The option has intrinsic value if the asset price is above the strike price.
- Exercising the Option: If the price of the asset exceeds the strike price, the buyer has the option to exercise it, securing a profit. They may also choose to sell their option for market value for a profit.
- Expiration: If the price of the underlying asset doesn't exceed the strike price by the expiration date, the option becomes worthless and the buyer forfeits the premium paid.
Understand How Investors Use Call Options
In an investment portfolio, call options are multi-purpose tools. The main reasons investors use call options include:
- Speculation: An investor can bet on the price taking off for an asset with minimal initial expenditure through call options. For instance, an investor can purchase a call option for a fraction of the price rather than buying 100 shares of a $50 stock ($5,000). This leverage magnifies gains, but also risk.
- Hedging: Call options may be used for insurance against price rise. A raw-materials-dependent company, for example, might buy call options on those commodities to hedge against price spikes.
- Generating Income: Call options can provide added income via covered calls, where an investor sells call options against stocks already owned, capturing options premiums as profit.
Benefits of Call Options
- Leverage: Call options give you exposure to bigger positions without having to put down as much money upfront, so the potential returns are magnified.
- Defined Risk for Buyers: The maximum loss for a call option buyer is the premium paid, no matter how far the underlying asset's price drops.
- Flexibility: Options can provide huge leverage in a wide variety of strategies — from aggressive speculation to conservative hedging.
- Enhanced Portfolio Returns: Call options allow investors to make money in bull markets without having to put up an outsized amount of capital to buy the stock flat out.
Risks of Call Options
- Limited Time Horizon: Different from stocks, which can be held indefinitely for as long as intended, call options have an expiry date. If the anticipated move in price doesn’t happen within the time frame, the option expires worthless.
- Premium Loss: If the option expires out of the money, the entire premium paid for the option is at risk.
- Volatility Risks: Though volatility can raise the value of an option, too much market twitching can render pricing erratic and hazardous.
Scenario 3: Key Metrics for Evaluating Call Options
| Metric | Definition |
|---|---|
| Intrinsic Value | Current price of the asset — strike price — in case if (current price of the asset — strike price) > 0 |
| Time Value | The portion of the premium that is based on the amount of time remaining until expiration. |
| Delta | Indicates the sensitivity of an option's price to a $1 change in the price of the underlying asset. |
| Theta | Indicates how fast the option’s price weakens as expiration nears. |
How to Use Call Options: Strategies
Covered Call:
- What It Is: Writing a call option against stock you already own.
- Objective: Earn income on the premiums and potentially wind up selling the stock at a higher level.
- Best For: Investors looking for income and neutral to slightly positive on the stock.
Long Call:
- What It Is: Buying a call option to capitalize on an expected price rise.
- Objective: Profiting on upward price action with minimal risk.
- Best For: Investors who want the chance for high returns without owning the underlying stock.
Protective Call:
- What It Is: Purchasing a call option to protect yourself against potential price increases in an asset you are planning to buy in the future.
- Objective: Ensure the top purchase price is fixed, while still retaining some upside.
- Best For: Hedgers with future costs.
Call Option In Action Example
Situation: A stock is priced at $100. You buy a call option with a $110 strike price for $3/share.
- Outcome A - Price Increases: If the stock increases to $120, your call option is worth $10 per share intrinsically. Once you subtract the $3 premium, your net gain is $7/share.
- Outcome B – Price Drops: If the stock price is below $110, the option expires worthless so you will lose your premium (in this case your loss is limited to $3).
When to Avoid Call Options
- High Volatility Periods: Premiums can be higher, limiting potential profitability.
- Short Expiration Periods: With minimal time for the underlying asset to gain ground positively, it is riskier.
- Ignorance: New traders need to understand the mechanics and risks before trading real money in the options market.
End Note: Call Options — An Awesome Force
Perhaps, such an option even had something giving it a few other advantages. However, to achieve this, they need a comprehensive understanding of the risks governing the mechanics. Using strategic utilization of call options can be a powerful tool in your investment toolbox whether you’re speculating, hedging, or generating income.
Buyers of call options need to be very careful on how to use it in order to avoid losing their money because they don't suit their profit and risk goals. Call options represent substantial opportunities in the financial markets when applied with the proper knowledge and disciplined strategy.