When you are investing in the stock market, there are a variety of investment options to choose from. One such option is a call option. Many investors may not know what call options are. If this sounds like you, don't worry.
In this article, we will explain in detail what call options are and how they work. We will also provide an example of how they can be used.
Finally, we will discuss some of the risks associated with call options and why someone might choose to buy them.
What is a call option?
A call option is a contract that gives the buyer the right, but not the obligation, to buy shares of a particular stock at a predetermined price within a certain time period.
The strike price is the price at which the buyer has the right to purchase the stock. The expiration date is the date by which the option must be exercised or it expires.
How do call options work?
If the stock price goes up above the strike price before expiration, you can exercise your option and buy shares of the stock at the strike price. If the stock price doesn't reach the strike price, you will lose your investment.
Call option examples
Example 1
Let's say you are interested in buying shares of OneTwoThree Corporation. The current share price is $100. You believe the stock will increase in value, but you do not want to pay the full price today.
You decide to buy a call option with a strike price of $110 and an expiration date of one month from today. The premium is $15 per share, so you pay the seller $1500 for the option. ($15 x 100 shares).
One month later, the stock price of ABC Corporation is $120. The call option is now in-the-money and you exercise your right to buy the shares at $110. You then sell the shares for $120, making a profit of $1000. ($120 - $110 = $1000).
Example 2
Now let's say you are interested in buying shares of XYZ Corporation. The current share price is $100. You decide to buy a call option with a strike price of $110 and an expiration date of one month from today. The premium is $15 per share, so you pay the seller $1500 for the option ($15 x 100 shares).
One month later, the stock price of XYZ Corporation is $105. The call option is now out-of-the-money and expires worthless. You lose your entire investment of $1500.
Risks of call options
When it comes to trading options, there are a few risks to be aware of when buying call options.
First, you could lose the entire premium you paid for the option if it expires out-of-the-money.
Second, call options are subject to time decay. This means that as expiration approaches, the value of the option decreases even if the stock price stays the same. This is because you have less time for the stock price to increase above the strike price.
Finally, call options are also subject to volatility risk. This is the risk that the stock price will move up or down sharply, making it difficult to predict where it will be at expiration.
Why would you buy a call option?
There are three main reasons why someone might choose to buy call options: speculation, hedging, and leverage.
Speculation
Buying call options is a way to make money if you think the stock price will go up. This is because you can buy the option for less than the stock price and sell it later for a profit.
Hedging
Call options can be used to hedge against an existing position in the stock market. For example, let's say you own 100 shares of XYZ Corporation. You are worried the stock price will go down, so you buy a call option with a strike price below the current stock price as insurance.
Leverage
Call options can be used to increase your potential return on investment. This is because you can control a large number of shares with a relatively small amount of money.
How to buy a call option
Call options can be bought through a broker. You will need to provide the following information:
- The stock you want to buy the call option on
- The strike price of the call option
- The expiration date of the call option
- The premium you are willing to pay
How do call options make money?
There are 2 ways of making money with call options: buying and selling them.
Buying call options
If you think a stock is going to go up, you can make money by buying call options. If the stock price goes up, you can sell the option for a profit. If the stock price goes above the strike price, you can exercise your option to buy the stock and then sell it for a profit.
Essentially, they make money by giving you the option to buy a stock at a certain price. This optionality gives investors the potential to make money if the stock price goes up, while only risking the amount of the premium.
Selling call options
You can also sell a call option, which is a much more risky strategy. Investors often sell call options to generate additional income, or when they are bearish on a certain stock, as it is a way of shorting a stock with options. This allows them to receive a premium when they sell the call option to investors.
However, the risks associated with selling call options are higher than when buying. The reason is that if the stock goes above the strike price, and the investor you sold the call option to decides to exercise it, you are forced to sell the shares to the investor at the agreed strike price.
The risk increases if you are naked selling call options. This means you do not own the underlying stock, and you will be forced to buy it on the open market at whatever price it is trading if the call option is exercised.
How to make money with call options
To make money with call options, you have to be right about the direction of the stock price. If you think the stock price will go up, you buy a call option. If the stock price goes up, you can sell the call option for a profit or even exercise it.
As we mentioned, you can also make money by selling call options. A covered call is an options strategy where you own the underlying stock and sell call options against it. If the investor that buys the call option exercises their option, you are obligated to sell your shares at the strike price. However, you have already collected the premium, so you keep that as profit.
If you think the stock price will go down, instead of buying a put without owning the stock you can write a naked call. This means you are selling the call option to an investor hoping the price goes down, but you do not own the stock.
As you can see, there are a lot of options and opportunities to make money when it comes to options. It's important to do your research and understand the risks before you start trading.
What happens when a call option hits the strike price?
If the stock price is above the strike price at expiration, the call is worth money (intrinsic value). This is because you can sell the stock for more than the strike price. The difference between the stock price and the strike price is your profit.
If, however, the stock price is below the strike price at expiration, then the call option expires worthless and you lose your entire investment, the premium paid to purchase the call.
For a call to make money, not only does the stock have to be above its strike price, but it also has to be above where it was when purchased, taking into account time decay.
Time decay works against call holders in two ways:
1. It reduces the time the call holder has for the stock to move in their favor
2. It increases the probability that the option will expire worthless
Time decay is most pronounced in the last 30 days before expiration. This is because call options are wasting assets. This means their value declines as they approach expiration.
Theta is an option greek and a measure of the rate of decline in an option's price with the passage of time. It is sometimes referred to as time decay. For example, if you buy a call option with a Theta of -0.05, then over the course of one day all else being equal, your call option would decrease in value by $0.05.
Therefore, if you are buying call options, you not only have to be right about the direction of the stock, but you also have to factor in the effects of time decay working against you.
Even if the stock hits the strike price, you may not make money on the call because of time decay.
This is the amount of time until the expiration date. The closer you get to expiration, the less time there is for the stock price to move above the strike price. This results in a loss of value for the call option. You may still make money if the stock price is above the strike price when you sell, but it will be less than if you had sold earlier.
Can you lose money on call options?
There are a few ways you can lose money on a call option:
- Stock moves against you
If you bought a call option and the underlying stock price goes down, then your call option will lose value. You can also lose money if the stock price never reaches the strike price before expiration, you will lose 100% of your investment.
This is what happens when the call option expires out-of-the-money. Out-of-the-money means that the stock price is below the strike price. If you exercise an out-of-the-call option, you will still have to buy the stock at the higher strike price.
This is why it is important to do your research before buying call options. You should have a good reason to believe that the stock price will reach the strike price within the time frame you are holding the option.
- The stock price stays flat
You can also lose money if the stock stays the same or only moves slightly higher. This is due to time decay. Time decay refers to the fact that as expiration gets closer, all else being equal, option prices decline. This is because there is less time for the underlying stock to move and so there is less chance of making a profit.
- Paying too much for the call option
Another way you can lose money on call options is if you pay too much for them.
Remember that call options are a contract between two parties. The option buyer pays the option seller a premium for the right to buy the stock at a certain price. If the stock goes up, but not by enough to offset the premium paid, then you will lose money on your call option trade.
- Time decay
Sometimes call options can lose money even when the underlying stock goes up. This is because of something called "theta." Theta is the amount by which an option's price declines each day as expiration gets closer. So even if the stock goes up, theta can cause call options to lose money.
- Selling a call option
If you sold a call option you can also lose money if the stock moves above the strike price, you will lose money. The holder of the call option can exercise it, and you will be forced to sell the shares at the agreed strike price, whether you have them already or not.
- Not managing risk
You can also lose money if you don't manage your risk properly. Options trading is risky and it's important to understand all of the risks involved before trading. Many new traders make the mistake of thinking that they can simply buy call options and sit back and watch their profits grow. But this isn't always the case.
- Not understanding how options work
You can also lose money on call options if you don't understand how they work. Options are a complex financial instrument and it's important to understand all of the ins and outs before trading. Many new traders make the mistake of thinking that call options are a simple way to make money. But this isn't always the case.
Call options vs stocks: advantages
Here are the three main advantages of call options when compared to stocks:
- Leverage
- Limited risk
- You don’t have to buy the stock
Leverage
With call options, you only have to pay a small amount for a large potential return. This is because call options give you the right to buy shares at a fixed price, called the strike price.
Limited risk
Your maximum loss is limited to the premium you paid for the call option. This differs from buying the stock outright, where your potential loss can be 100% of the underlying asset.
You don't have to buy the stock
If you think the stock price will go up but don't want to commit to buying it, you can buy a call option instead. This way you still have the chance to make money if the stock price goes up without having to actually purchase the stock.
Call options vs stocks: disadvantages
There are also many disadvantages when it comes to buying call options. Here are the most common reasons why investors prefer stocks:
- Risk
- Time decay
- Volatile market
- Limited upside
- Options pricing
Risk
Call options are a risky investment because you can lose 100% of your money if the stock price doesn't reach the strike price before the expiration.
Time decay
The value of call options decreases as they get closer to expiration. This is because there is less time for the stock price to move above the strike price. It can be stressful knowing that your options are losing value every day.
Volatile market
Call options are more expensive in a volatile market because there is a higher chance that the stock price will reach the strike price.
Limited upside
Your potential profit is limited to the premium you paid for the call option. This is because you only have the right to purchase shares at the strike price, even if the stock goes up significantly in value.
Options pricing
Options are not like stocks, and they are complex financial derivatives that are difficult to value. For that reason trading options usually involve lower liquidity than stocks and wider bid-ask spreads. It is far too easy to overpay for options, and this could pose a serious threat to your returns.
Types of call options strategy
There are different types of call option strategies, which can be used depending on the investor's goals, such as:
- Covered call strategy
- Naked call strategy
- Long call strategy
- Short call strategy
Covered call strategy
This strategy is when the investor owns the underlying stock and writes or sells call options against it. This can provide income if the stock price stays relatively stable or rises modestly. If the stock price falls, the loss is limited to the premium received from selling the call option.
The covered call is a good way to generate income from your stock portfolio while still giving yourself the chance to profit if the stock price goes up.
Naked call strategy
This involves selling call options without owning the underlying shares. This is a risky strategy because the buyer of the option could exercise the option and force you to buy the shares. You would also have to buy them at the market price, which could be much higher than the strike price of the option.
This can be a high-risk move because if the stock price increases dramatically, there is no limit to how much money could be lost. If you are assigned the shares, you will also be responsible for any dividends that are paid out.
Long call strategy
This is when an investor buys call options with the hope that the stock price will rise so they can sell the option at a profit.
Short call strategy
This happens when an investor writes or sells call options and hopes that the stock price will fall so they can buy back the option at a lower price.
Common Questions About Call Options
How much money can you make with call options?
There is no limit to how much money you can make with call options. However, your profit will be limited by the premium you paid for the option, and your losses could potentially be unlimited.
Why is it called a call option?
The call option is so named because it gives the holder the right to call, or buy, the underlying security. It gives investors the 'option' to call the direction of the stock.
What is the risk of buying call options?
The biggest risk of buying call options is that the stock price could go down instead of up. If this happens, you will lose the premium that you paid for the option.
Another risk is that the company could go bankrupt before the expiration date, which would cause the value of the call option to drop to zero.
You can also lose 100% of your money if the stock price doesn't reach the strike price before the expiration. Call options are also more expensive in a volatile market because there is a higher chance that the stock price will reach the strike price.
What is a call option?
Call options are contracts that give you the right to buy shares of a stock at a fixed price, called the strike price.
How do call options work?
If the stock price goes up above the strike price before expiration, you can exercise your option and buy shares of the stock at the strike price. If the stock price doesn't reach the strike price, you will lose your investment.
Why would you buy a call option?
You might buy a call option if you think the stock price will go up but don't want to commit to buying the stock, or if you want to leverage your investment.
How to choose a call option to buy?
When considering which call option to buy, you should look at the strike price, expiration date, and premium.
You want to buy an option with a strike price that is below the current stock price. It's also helpful to buy one with an expiration date that is far enough in the future that you think the stock price will have time to reach the strike price. The premium is the amount you pay for the call option.
Which call option would be good to sell?
The best call option to sell is one with a strike price that is above the current stock price and an expiration date that is close to expiration.
What is the difference between a call option and a put option?
Call options give you the right to buy shares of a stock at a fixed price, while a put option gives you the right to sell shares of a stock at a fixed price.
What is an in-the-money call option?
An in-the-money call option is one where the strike price is below the current stock price. This means that if you exercised your option, you would make a profit.
What is an out-of-the-money call option?
An out-of-the-money call option is one where the strike price is greater than the current stock price. If you exercised your option, you would suffer a loss.
What is an at-the-money call option?
An at-the-money call option is one where the strike price is equal to the current stock price. This means that if you exercised your option, you would break even.
How do call options affect the market?
Call options can have a positive or negative effect on the market, depending on how they are used. If call options are used to speculate on the future price of a stock, they can have a positive effect by increasing the price of the stock.
However, if call options are used to hedge against a decline in the price of a stock, they can have a negative effect by decreasing the price of the stock.
What are some common mistakes people make with call options?
Some common mistakes include buying call options that are too expensive or selling call options without first doing your research.
What are some things to consider before buying call options?
You should consider the risks involved, the costs of the call options, and your investment goals. You should also make sure that you understand how call options work before buying them.
How to Exercise Call Options?
If you decide to exercise your call option, you will need to contact your broker. You will then need to provide them with the necessary information, such as the strike price and expiration date. Once your broker has this information, they will execute the trade for you.
When Should You Exercise Call Options?
You should exercise your call option when the stock price is above the strike price and you think it will continue to rise. If you exercise your call option early, you may miss out on profits if the stock price continues to rise.
What Happens When You Sell a Call Option?
If you sell a call option, you are giving the buyer the right to buy shares of the underlying stock at a fixed price. The buyer will pay you a premium for this right. If the stock price goes up, the buyer will make a profit, and you will make a loss. If the stock price goes down, you will make a profit, and the buyer will make a loss.
Where to buy Call Options?
The CBOE (Chicago Board Options Exchange) is the largest options exchange in the US. You can also buy call options through online brokers.
Conclusion
Call options can be a good investment if you think the stock price will go up but don't want to commit to buying the stock. You can also make money with call options by holding on to the option and selling it later at a higher price.
However, you can lose 100% of your money if the stock price doesn't reach the strike price before the expiration through the premium that you paid. Call options are great for investors who are looking for leverage and don't mind taking on some extra risk.
Now that you know more about call options, you can decide if they're the right investment for you. Just remember to do your research and understand all of the risks involved before trading. With call options, you have the potential to make a lot of money, but they can be a complex investment strategy.
Hopefully, this article helped you better understand call options and how they work. Remember to do your own research before trading and always understand the risks involved.
