Call Option Definition

1. Call options

Calls give the buyer the right, but not the obligation, to buy the underlying asset at the strike price specified in the option contract. Investors buy calls when they believe the price of the underlying asset will increase and sell calls if they believe it will decrease.

A call option may be contrasted with a put option, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.

KEY TAKEAWAYS

  • A call is an option contract giving the owner the right but not the obligation to buy a specified amount of an underlying security at a specified price within a specified time.
  • The specified price is known as the strike price, and the specified time during which the sale can be made is its expiration or time to maturity.
  • You pay a fee to purchase a call option, called the premium; this per-share charge is the maximum you can lose on a call option.
  • You can go long on a call option by buying it or short a call option by selling it.
  • Call options may be purchased for speculation or sold for income purposes or for tax management.
  • Call options may also be combined for use in spread or combination strategies.

 Types of Call Options

There are two types of call options as described below.

  • Long call option: A long call option is, simply, your standard call option in which the buyer has the right, but not the obligation, to buy a stock at a strike price in the future. The advantage of a long call is that it allows you to plan ahead to purchase a stock at a cheaper price. For example, you might purchase a long call option in anticipation of a newsworthy event, say a company’s earnings call. While the profits on a long call option may be unlimited, the losses are limited to premiums. Thus, even if the company does not report a positive earnings beat (or one that does not meet market expectations) and the price of its shares decline, the maximum losses that the buyer of a call option will bear are limited to the premiums paid for the
  • https://youtu.be/nnl3x1wo25goption.
  • Short call option: As its name indicates, a short call option is the opposite of a long call option. In a short call option, the seller promises to sell their shares at a fixed strike price in the future. Short call options are mainly used for covered calls by the option seller, or call options in which the seller already owns the underlying stock for their options. The call helps contain the losses that they might suffer if the trade does not go their way. For example, their losses would multiply if the call were uncovered (i.e., they did not own the underlying stock for their option) and the stock appreciated significantly in price.

How Do Call Options Work?

Call options are a type of derivative contract that gives the holder the right but not the obligation to purchase a specified number of shares at a predetermined price, known as the “strike price” of the option. If the market price of the stock rises above the option’s strike price, the option holder can exercise their option, buying at the strike price and selling at the higher market price in order to lock in a profit. Options only last for a limited period of time; however. If the market price does not rise above the strike price during that period, the options expire worthless.

Why Would You Buy a Call Option?

Investors will consider buying call options if they are optimistic—or “bullish”—about the prospects of its underlying shares. For these investors, call options might provide a more attractive way to speculate on the prospects of a company because of the leverage that they provide. After all, each options contract provides the opportunity to buy 100 shares of the company in question. For an investor who is confident that a company’s shares will rise, buying shares indirectly through call options can be an attractive way to increase their purchasing power.

Is Buying a Call Bullish or Bearish?

Buying calls is a bullish behavior because the buyer only profits if the price of the shares rises. Conversely, selling call options is a bearish behavior, because the seller profits if the shares do not rise. Whereas the profits of a call buyer are theoretically unlimited, the profits of a call seller are limited to the premium they receive when they sell the calls.

Put options

Puts give the buyer the right, but not the obligation, to sell the underlying asset at the strike price specified in the contract. The writer (seller) of the put option is obligated to buy the asset if the put buyer exercises their option. Investors buy puts when they believe the price of the underlying asset will decrease and sell puts if they believe it will increase.

Payoffs for Options: Calls and Puts

Calls             

The buyer of a call option pays the option premium in full at the time of entering the contract. Afterward, the buyer enjoys a potential profit should the market move in his favor. There is no possibility of the option generating any further loss beyond the purchase price. This is one of the most attractive features of buying options. For a limited investment, the buyer secures unlimited profit potential with a known and strictly limited potential loss.

If the spot price of the underlying asset does not rise above the option strike price prior to the option’s expiration, then the investor loses the amount they paid for the option. However, if the price of the underlying asset does exceed the strike price, then the call buyer makes a profit. The amount of profit is the difference between the market price and the option’s strike price, multiplied by the incremental value of the underlying asset, minus the price paid for the option.

For example, a stock option is for 100 shares of the underlying stock. Assume a trader buys one call option contract on ABC stock with a strike price of $25. He pays $150 for the option. On the option’s expiration date, ABC stock shares are selling for $35. The buyer/holder of the option exercises his right to purchase 100 shares of ABC at $25 a share (the option’s strike price). He immediately sells the shares at the current market price of $35 per share.

He paid $2,500 for the 100 shares ($25 x 100) and sells the shares for $3,500 ($35 x 100). His profit from the option is $1,000 ($3,500 – $2,500), minus the $150 premium paid for the option. Thus, his net profit, excluding transaction costs, is $850 ($1,000 – $150). That’s a very nice return on investment (ROI) for just a $150 investment.

Selling Call Options

The call option seller’s downside is potentially unlimited. As the spot price of the underlying asset exceeds the strike price, the writer of the option incurs a loss accordingly (equal to the option buyer ‘s profit). However, if the market price of the underlying asset does not go higher than the option strike price, then the option expires worthless. The option seller profits in the amount of the premium they received for the option.

An example is portrayed below, indicating the potential payoff for a call option on RBC stock, with an option premium of $10 and a strike price of $100. In the example, the buyer incurs a $10 loss if the share price of RBC does not increase past $100. Conversely, the writer of the call is in-the-money as long as the share price remains below $100.

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