When it comes to investments, there are a lot of different options to choose from. One of the most popular investment vehicles is called a call option. But what exactly is a call option? How do they work? And can you make money with them?
In this guide, we will answer all of those questions and more! We will explain what a call option is, how they work, and give you an example of one. We will also discuss the risks associated with investing in call options.
What is a call option?
A call option is a contract that gives the holder the right, but not the obligation, to buy an underlying asset at a specified price within a specific time period. Call options are typically used as a way to speculate on the future price of an asset, such as a stock.
For example, let's say you believe that ABC stock is going to increase in price over the next year. You could buy a call option that gives you the right to purchase shares of ABC stock at $100 per share within the next year.
If the stock does indeed increase in price to $150, you can then exercise your option and buy the shares at $100 each, and sell them immediately for a profit. On the other hand, if the stock price does not increase, you can simply let the option expire and you will not have to purchase the shares. You would only lose the premium that you paid for the option.
There are two main types of call options
American-style options can be exercised anytime up until expiration, while European-style options can only be exercised on the expiration date. When it comes to European-style options, they are typically less expensive than American-style options because they have a lower risk of being exercised early.
The type of option you buy will depend on your investment strategy and goals. Now that we know what a call option is let's discuss how they work and the risks involved with investing in them.
How call options work
Call options are contracts that allow investors to buy a specific number of shares of a stock at a fixed price for a specified time period, called the "life" of the contract. The buyer of this type of option pays a premium to the seller, who is obligated to sell those shares at the agreed-upon price.
The buyer has no obligation to buy those shares; they only must pay the agreed-upon price if they wish to exercise their right to buy them. If the stock price goes above the strike price before the expiration day, then it's possible for someone holding call options on that stock to make money without ever actually purchasing any shares. This is called being "in the money."
Example of a call option
Call options are a type of derivative security, which means that they derive their value from some other asset. In this case, the asset is stock. A call option (also known as a "call") gives the holder the right to buy a specified number of shares at a fixed price within a specific time frame.
For example, if you have one call option for 100 shares, then you have the right to buy 100 shares at $1 per share until the expiration date (which is one year from now).
If your company's stock rises above $1 per share before then, your call will be valuable because it allows you to buy those shares at $1 instead of whatever the current market price happens to be.
If it falls below $1 per share, though, then this right isn't worth much—and if it falls all the way down to zero (meaning no one wants to buy any stock at all), then your call will be worthless.
How are options priced?
The price of an option is determined by several factors. The most important factor is the current value of the underlying asset. The value of an option depends on the difference between its strike price and the current value of the underlying asset.
If you own a call option, and you are expecting the stock price to rise above $100, then your call will be worth more money as long as it's more than $100. If it's less than $100, then it's not worth very much at all.
Another factor is time until expiration—the longer you have until expiration, the more valuable your option becomes because there's more time for it to be exercised or sold before expiry.
What is the expiration date?
When you buy a call option, you are buying the right to buy a specific stock at a specific price and time. You can exercise this right any time before the option's expiration date.
The expiration date is when your ability to exercise your call option ends. If you decide not to exercise it by that date, then the option will expire worthlessly, and you will lose the money you paid for it.
What is an option premium?
The option premium is the price of the option contract. It is composed of two parts: the intrinsic value and the time value.
The intrinsic value is the difference between the strike price and the underlying asset's spot price. The time value is what an investor pays for the chance that the option will increase in value. It is also referred to as extrinsic value.
Time value is affected by factors such as the length of time until the expiration date, volatility, and interest rates. Premium just means price.
Can you make money with call options?
Yes, you can make money with call options. Call options are a type of contract that gives the buyer the right, but not the obligation, to buy a specified amount of an asset at a predetermined price within a given period. Let's say you want to make money with call options.
You would start by buying a call option for an asset that you expect will go up in value over time. Then, if your prediction turns out to be true and the value of the asset increases over time, you'll be able to sell your call option for more than what you paid for it.
For example: Let's say you buy a call option on Apple stock because you believe it will rise in value over time. If Apple stock does indeed rise in price, then when the contract expires (after some agreed-upon amount of time), you can sell your call option at its higher value and make money off of it!
How to make money with call options
When you buy a call option, you're buying the right to buy a stock at a certain price at any point in the future. This means that if the price of the stock goes up, you're able to buy it for less than its current market value.
If it goes down, though, your option will expire worthless and you won't be able to buy the stock at all. You can also make money with call options by selling them on other people's stocks—when they expire worthless.
If someone else buys one from you and the stock doesn't go up enough by expiration day, they'll have wasted their money because they still have to pay for it anyway (unless they buy another one from someone else).
The only thing to remember about trading options is that there's always a chance that something might happen that affects their value before expiration day arrives. This means that if you're trading them as an investor or trader yourself then you need to understand what might happen over time so that you don't end up losing too much money when things go wrong unexpectedly!
Can you lose money on call options?
Yes, you can lose money on call options. The price of the asset will increase over time as long as it is above the strike price, which is set when you buy the option and determines how much profit you make if your prediction is correct.
However, if you buy an option and then wait until it expires without selling it to realize any profit, then you will lose money on that investment.
If the price of the asset goes down instead of up or remains stable, then there is no opportunity for profit with this type of investment.
Can you trade options without owning the stock?
Yes, you can trade options without owning the stock. This is one of the most unique and useful aspects of options trading. Let's say you have an idea for a new product. You think it could be a success, but you aren't sure if it will be.
You might consider buying shares in the company that owns the patent for your idea, just in case your product does catch on, and sales go through the roof. But what if you want to hedge your risk? What if you don't have enough money to buy all those shares?
This is where call options come in. Call options are contracts that give their buyer the right to buy shares of stock at a set price (the strike price) by a specific date (the expiration date). If the price of those stocks rises above that strike price before expiration day, then your option becomes more valuable—and vice versa: if it doesn't rise enough, or falls below that strike price, then your option loses value.
Risks of call options
Even though call options are considered one of the most popular ways to invest in the stock market, they are also one of the riskiest. When you buy a call option, you have the right to buy shares at a certain price. If you sell them before they expire, you will lose money.
If you hold onto them until they expire, and it turns out that the shares are worth more than what you paid for it, then your call option is worth more than what you paid for it. The problem with call options is that even though they can be very profitable, they are also very risky and can lead to huge losses if not handled properly.
The price of the stock goes down: If the price of your stock goes down, you can sell it to someone else for a higher price. This is called "selling short." When you sell short, you make money when the market goes down.
In this case, your call option will expire worthless because you don't have to buy the stock at $100 anymore. You can buy it on the open market at whatever its current value—either less than $100 or more than $100.
The price of the stock stays unchanged: If the price of your stock stays unchanged, you will still have to buy it at $100 when your call option expires. In this case, you would lose money on your investment because you could have just bought the stock outright for $100 and sold it later for the same price.
The price of the stock goes up but not enough to make a profit on the call option: If the price of your stock goes up but not enough to make a profit on the call option, you will still have to buy it at $100 when your call option expires. In this case, you would lose money on your investment because you could have just bought the stock outright for $100 and sold it later for the same price.