What is a Call Option?
A call option is a financial contract that provides the option buyer the right, but not the obligation, to buy an asset at a selected price within a selected time frame. These are called “call” options because they represent the right to “call” for the asset.
Call options are financial derivatives because their value is based on and derived from an asset with which it is associated with. The asset, which is called the underlying asset, can come in many forms. It can be shares of financial stock of companies, bonds, commodities, etc.
The opposite of a call option would be a put option.
How does a call option work?
A call option based on stock allows the owner of the option the right to purchase 100 shares of that stock at a pre-determined price before or on a certain date. The pre-determined price is called the strike price while the date is called the expiration date.
Generally speaking, a call option will rise in value when the underlying stock rises in price. However, it isn’t a good idea to simply think that a call option will increase in value if the underlying stock rises because this is too simplistic. A call option will also decrease in value as you approach the expiration date. Additionally, if there is external information that indicates an important event is coming up that might cause the underlying stock to increase in price, the value of the call option will also rise in anticipation. All of these factors combine to determine the value of a call option.
One important point to keep in mind is that the prices of options are almost always shown per share of stock. Since each option represents 100 shares, the actual price will be the price you see times 100. For example, a call option might be shown in a quote to cost $1.25. If you were to buy this option, it would cost $125. Most brokerage firms will usually show you a confirmation prompt after you enter an order asking you to double check before submitting the order. This confirmation prompt should automatically show you the actual price.
What is the maximum I can gain or lose?
If you are long a call option, meaning you buy a call option to open a position, the max you can gain is theoretically unlimited assuming the stock has no maximum price while the max you can lose is just the initial price you paid for the call option.
Max Gain = Unlimited
Max Loss = Initial price you paid to buy the call option
Check out the below chart that illustrates the outcomes of a call option that is bought at the example price of $100.
If you are short a call option, meaning you sell a call option to open a position, the situation is reversed. The max you can gain is just the initial price you received when you sold the call option and the max you can lose is theoretically unlimited.
Max Gain = Initial price you received when you sold the call option
Max Loss = Unlimited
Check out the below chart that illustrates the outcomes of a call option that is sold at the example price of $100.
What are the parts of a call option’s price?
The price of a call option is called the premium and contains two parts, the extrinsic value and the intrinsic value.
Option Price = Extrinsic Value + Intrinsic Value
The extrinsic value is the value that is purely from the option itself and external from the underlying stock. It is always a positive non-zero number. The easiest way to calculate this is to simply subtract the intrinsic value, if any, from the option price.
Extrinsic Value = Option Value – Intrinsic Value
This then leads to the question, how do we calculate the intrinsic value? The intrinsic value represents the value, if any, that would be produced if you were to immediately exercise the option. For call options, the intrinsic value can be calculated by simply taking the current price of the underlying stock and subtracting the strike price.
Intrinsic Value = Current Price of Stock – Strike Price
The intrinsic value is always either a positive non-zero number or zero. You either have some intrinsic value or you have none. If the current price of the stock is below the strike price, a call option has no intrinsic value and entirety of the option value is extrinsic.
How do you activate your call option to buy shares?
If you want to activate your call option to buy shares, you would have to exercise your call option contract. The method to exercising your option depends on your brokerage firm. Some will require you to contact customer support while some may allow doing so through an online interface. Keep in mind that in order to purchase the 100 shares that a call option represents, you will need to have enough cash in your account to cover 100 shares at the strike price of your call option. Additionally, there may also be fees and commissions to exercise an option.
If you end up exercising your call option without enough cash in your account, the brokerage firm will often loan you money in the form of margin. Keep in mind that margin is borrowed money, which not only has interest fees, but is something you will eventually have to return back to the brokerage.
For example, if you own a call option for Apple stock with a strike price of $100, exercising the call option will require that you have enough cash to purchase 100 shares of Apple stock at $100, which equals $10,000.
Why would someone buy a call option?
Due to the structure of how options are priced and the fact that they represent 100 shares of stock, they can provide significant exposure and leverage. Coupled with the fact that they can be bought for relatively low prices, it’s no wonder that these can be used to speculate on the movement of stock. If traders are bullish, they may buy call options to speculate that a stock will continue rising in price.
Traders also take advantage of the pre-determined maximum loss on long call options (the initial price you paid to buy the call options) to precisely define and control their risk.
Lastly, call options may be combined with other call or put options to create different profit and loss scenarios that may better suit different situations.
Selling Covered Calls for Income
The covered call strategy involves owning at least 100 shares of a stock and selling call options. This allows one to collect the revenue from the sale of the call option while the buyer on the other side of the transaction would have the right to potentially buy the shares of stock you own. In essence, you are putting your shares of stock up as collateral to collect income by selling call options.
Investors who partake in the covered call strategy collect option premium on the hope that the stock price will rise so that their shares of stock become more valuable but stays under the call option’s strike price when the option expires. If the stock price is below the call option’s strike price, the buyer of the call option will have no incentive to exercise the option to buy your shares because there would be no profit. Afterwards, the investor may consider repeating the process to sell new call options once the previous ones have expired.
This strategy can produce income for the investor, but can limit the profit potential of the investor’s stock holding because if the stock price rises above the call option’s strike price, the buyer of the call option may consider exercising the option which may then force the investor to sell his shares of stock away.