Call Options: An Introduction and How to Trade Them
Call options are financial contracts that give the holder the right – but not the obligation – to purchase an underlying stock or asset at a specified price at a specified time or up until that specified time. Generally, when an investor buys a call option, they think the price of the underlying stock will go up and the option holder will make money as the price of the underlying stock increases.
You can buy call options to speculate on stock prices and magnify your returns. Or you can sell them to collect income if you are bearish on the price of the underlying stock.
Investors can make a lot of money using options. But options can also pose significant risks. In this article, we will go into detail on call options and how to use them.
What Are Call Options?
Purchasing a call option on a stock is different from purchasing the stock outright. For example, let’s say a stock – we’ll call it XYZ Stock – is currently trading at $100. If you think the price of XYZ Stock is going to increase over time, you might buy 100 shares of the stock directly.
But another strategy is to buy a call option on the stock. The price you pay to buy a call option is known as a premium. Often, the price of a stock option is low compared with the price of the underlying stock, so it can require a much lower initial cash outlay than buying a full share of a stock.
Let’s say you purchase a call option on 100 shares of XYZ stock for $500 that expires on December 20. Up to that date, you can purchase the shares at this specified price, or you can simply let the option expire. The higher the price of XYZ stock is above the strike price when you execute the option, the more money you will make on the trade.
Features of Call Options
There are different features of call options that you should be familiar with:
- The Premium – The current purchase price of a call option
- Strike Price – The specified purchase price of the underlying stock the investor has the right to purchase
- Expiration Date (Strike Date) – The date on which or up until the option holder can purchase the underlying stock
- Time to Maturity – The time remaining until the expiration date.
Factors like the strike price, the expiration date and the current price of the underlying stock help to determine the premium of a call option. For example, as the share price of XYZ stock increases, the premium for the call option will increase as well. The opposite is also true.
An Example of How It Works
Sticking with our beloved XYZ stock, let’s say that the current price of the stock is $100, and you purchase a call option to buy 100 shares with a strike price of $100 and an expiration date of December 20. The premium you pay for the option is $500.
On December 20, XYZ stock is trading at $110. Because the call option you hold is in the money, you exercise the option and buy 100 shares of XYZ stock for $100 each, or $100 x 100 shares = $10,000.
You can now sell these shares on the open market for $110 per share. You sell all your shares at this price for a total of $11,000. The spread between what you earned and what you spent is $11,000 – $10,000 = $1,000.
To calculate your total return on the call option, you need to factor in the premium you paid to purchase the option. So your total return on the trade would be ($11,000 – $10,000 – $500) / $500 = $500. $500 profit / $500 initial investment = 100% return. Not too shabby!
Another feature of call options is that in addition to buying them, you can also sell them. When you sell call options, you immediately earn the premium price you are paid for the option. Continuing our storied XYZ example, let’s say you are the seller in the transaction, and you sell an option on 100 shares of XYZ stock for a premium of $500.
The $500 premium paid to you is now your income to keep. However, the contract obligates you to sell shares of XYZ to the option holder if they decide to exercise the option on the expiration date.
If the price of XYZ is below the strike price on the expiration date, the option becomes worthless and you get to keep the entire $500 as your income on the trade.
However, let’s say that the stock is trading at $110 on the expiration date and the holder exercises the option. Now you are obligated to sell them 100 shares of XYZ stock for $100 each.
You purchase 100 shares on the open market for $110 x 100 = $11,000 and then sell them to the option holder for $10,000. The difference between your sale price and your purchase price is $10,000 – $11,000 = -$1,000, which is a loss for you. Though you earned $500 in income from the initial sale of the call option, this is more than wiped out by the loss on the final transaction at expiration. Your total loss on the transaction after accounting for the $500 you earned from the premium would be -$500.
The higher the underlying share price above the strike price on the expiration date, the more money you would lose on the trade. Therefore, selling call options can be a risky strategy because there is no limit to how high a stock can appreciate above its strike price.
Concluding Thoughts on Call Options
Call options can be a useful tool for making large returns in a relatively short amount of time. Compared with buying an individual stock at full price, buying a call option on the stock can quickly magnify your gains in a major way.
If you’re interested in learning more about how to trade options, just sign up for our free e-letter Trade of the Day. You’ll learn a lot about call options, put options and the strategies you can use to make money from them.
Now that you have a more thorough understanding of call options, you can use them to make money by buying, selling or using them in combination with other options and assets to make profits. And keep an eye out for the next article in this series on options trading where we discuss put options.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.