What is a call option?

Definition and Examples of Call Options

How Call Options Work

Selling Call Options

Call Option vs. Put Option

Definition and Examples of Call Options

A call option is an agreement that gives you the right to buy stocks, bonds, commodities, or other securities at a specified price until a specified expiration date.

A call option is a contract between two parties that gives the buyer of the option the right to buy the underlying security or commodity or contract. The terms of the deal are specified in the contract – the specified price at which the purchase will be made (strike price) and the time frame for executing it (exercise date). The buyer pays a small fee or premium for this right. Call option contracts are sold in lots consisting of 100 shares. After the exercise date, the option ceases to exist.

Note: The buyer of a call option is not obligated to exercise the purchase and execute the transaction. The buyer still pays the premium even if the purchase is not executed. On the other hand, the seller is obligated to sell the security at the specified price upon the buyer’s request.

How Call Options Work

You can buy or sell call options depending on your expectations for the price of the underlying security. Depending on your trading strategy, you may choose to exercise the option, let it expire, or sell the call option contract.

It makes sense to buy a call option if you believe the security may increase in value before the exercise date.

For example, a call option might look like this: XYZ December 80 call at $1.20. This means it is a call option contract for shares of XYZ, expiring in December, with a strike price of $80 and a premium of $1.20.

Typically, traditional options expire on the third Friday of each month. Some options contracts specify other expiration dates.

If you want to determine the buyer’s profit from a call option, all you need to do is start with the price of the underlying security, then subtract the strike price, the option premium, and any transaction fees, and you will arrive at your option profit or intrinsic value. The strike price ultimately determines whether the option has intrinsic value. While you can also make a profitable trade by selling a call option contract, we will only consider call options that the buyer exercises or lets expire in this article.

For example, suppose Sam owns 100 shares of XYZ, priced at $70 per share. If Mary believes that the company’s stock will increase in value, she may buy a call option to purchase those shares at a strike price of $80. If the stock price reaches $90 before the exercise date and Mary exercises the option, she realizes a profit of $10 per share. The total profit amounts to $1,000 (100 shares × $10 profit per share).

You must consider that Mary paid Sam $1.20 per share as a premium, totaling $120. This reduces Mary’s net profit to $880 ($1,000 – $120). Transaction fees may further reduce the net profit.

Selling Call Options

The seller of a call option is known as the writer. A person sells a call option if they are losing money or neutral on the asset. Remember that the seller receives the premium whether the call option is exercised or not. There are two ways to sell call options.

Naked Call Option: A naked call option occurs when you sell a call option without owning the underlying asset. It is a risky decision. If the buyer exercises the option, you will have to purchase the asset at market price to meet the demand. If the price is higher than the strike price, you will lose the difference minus the fees you paid.

Note:

There is no limit to the potential loss in naked call options due to the absence of a cap on the asset’s price increase. You must hope that the premiums you collect are more than sufficient to cover the risk.

Most writers of naked call options are large companies that can diversify their risks. Their profits from many premiums on options they correctly guess outweigh sporadic losses on the option that goes against them. These companies have analysts with computer programs that calculate all of this for them.

Covered call: If you are considering selling an asset you already own, you may want to sell a covered call option on it instead. You receive risk-free income from the premium you collect from the option. You also earn money when the strike price is higher than the amount you originally paid, and the buyer exercises the option. This type of option is called a “covered call” because the option is “covered” by the underlying asset.

The risk of a covered call is missing the opportunity for gains if the stock price rises. You cannot sell your shares at a higher price and keep the profit. Instead, you must sell the agreed-upon amount of shares to the call option holder at the strike price. You will keep the premium, but the call option holder will gain the net profit from the stock price increase.

Many writers of covered calls enjoy the risk-free income from the premium. If you have substantial assets and need cash now, a covered call option might be a good choice.

Call Option vs. Put Option

The investor in a put option bets on the stock price falling below the strike price. The put option holder has the right to sell the security at a specified price at any time during the exercise period.

Note: A put option is in the money if the underlying security’s price is below the strike price. If the underlying security’s price rises above the strike price, the put option becomes out of the money.

The intrinsic value of a put option is the difference between the current price of the underlying security and the strike price of the option. The put option holder will not exercise the option if the price does not fall below the strike price. Here too, the put option seller keeps the premium whether the option is exercised or not.

One advantage of call and put options is that investors can enter contracts with limited capital, as the initial investment is only the premium price. Options trading strategies can be risky and are not suitable for everyone.

The table below compares call options and put options.

Call Option: The buyer has the right, but not the obligation, to purchase the agreed-upon underlying security at the strike price by the expiration date. The option is in the money when the underlying security’s price is higher than the strike price. The option loses value or is out of the money when the underlying security’s price is less than the strike price.

Put Option: The holder of the put option has the right to sell the underlying security at a specified price at any time during the exercise period. The option is in the money when the underlying security’s price is less than the strike price. If the underlying security’s price rises above the strike price, the put option becomes out of the money.

Key Takeaways

A call option gives the investor the right to buy an underlying asset (often stock shares) at a specific price (strike price) within a specified time frame. Investing in call options makes sense if you expect the underlying asset’s price to rise. The buyer of the call option pays a premium for the right to purchase the stock. If the option is not exercised, the buyer’s loss is limited to the premium. Options are a way to hedge risks for the buyer and a means of generating income for the option seller.

Source:

https://www.thebalancemoney.com/call-option-definition-types-pros-cons-3305823