Call options are a type of option that increases in value when a stock rises. They’re the best-known kind of option, and they allow the owner to lock in a price to buy a specific stock by a specific date. Call options are appealing because they can appreciate quickly on a small move up in the stock price. So that makes them a favorite with traders who are looking for a big gain.
The other major kind of option is a put option, and its value increases as a stock price declines. (Here’s what you need to know about put options.)
How does a call option work?
A call option gives you the right, but not the requirement, to purchase a stock at a specific price (known as the strike price) by a specific date, at the option’s expiration. For this right, the call buyer will pay an amount of money called a premium, which the call seller will receive. Unlike stocks, which can live in perpetuity, an option will cease to exist after expiration, ending up either worthless or with some value.
The following components comprise the major traits of an option:
- Strike price: The price at which you can buy the underlying stock
- Premium: The price of the option, for either buyer or seller
- Expiration: When the option expires and is settled
One option is called a contract, and each contract represents 100 shares of the underlying stock. Exchanges quote options prices in terms of the per-share price, not the total price you must pay to own the contract. For example, an option may be quoted at $0.75 on the exchange. So to purchase one contract it will cost (100 shares * 1 contract * $0.75), or $75.
Call options are in the money when the stock price is above the strike price at expiration. The call owner can exercise the option, putting up cash to buy the stock at the strike price. Or the owner can simply sell the option at its fair market value to another buyer.
A call owner profits when the premium paid is less than the difference between the stock price and the strike price. For example, imagine a trader bought a call for $0.50 with a strike price of $20, and the stock is $23. The option is worth $3 and the trader has made a profit of $2.50.
If the stock price is below the strike price at expiration, then the call is out of the money and expires worthless. The call seller keeps any premium received for the option.
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Why buy a call option?
The biggest advantage of buying a call option is that it magnifies the gains in a stock’s price. For a relatively small upfront cost, you can enjoy a stock’s gains above the strike price until the option expires. So if you’re buying a call, you usually expect the stock to rise before expiration.
Imagine that a stock named XYZ is trading at $20 per share. You can buy a call on the stock with a $20 strike price for $2 with an expiration in eight months. One contract costs $200, or $2 * * 1 contract * 100 shares.
Here’s the trader’s profit at expiration.
As you can see, above the strike price the value of the option increases $100 for every one dollar increase in the stock price. As the stock moves from $23 to $24 – a gain of just 4.3 percent – the trader’s profit increases by 100 percent, from $100 to $200.
While the option may be in the money at expiration, the trader may not have made a profit. In this example, the premium cost $2 per contract, so the option breaks even at $22 per share, the $20 strike price plus the $2 premium. Only above that level does the call buyer make money.
If the stock finishes between $20 and $22, the call option will still have some value, but overall the trader will lose money. And below $20 per share, the option expires worthless and the call buyer loses the entire investment.
The appeal of buying calls is that they drastically magnify a trader’s profits, as compared to owning the stock directly. With the same initial investment of $200, a trader could buy 10 shares of stock or one call.
If the stock finishes at $24, then…
- The stock investor makes a profit of $40, or (10 shares * $4 gain).
- The options trader makes a profit of $200, or the $400 option value (100 shares * 1 contract * $4 gain) minus the $200 premium paid for the call.
When comparing in percentage terms, the stock returns 20 percent while the option returns 100 percent.
[READ: How to buy stocks]
Why sell a call option?
For every call bought, there is a call sold. So what are the advantages of selling a call? In short, the payoff structure is exactly the reverse for buying a call. Call sellers expect the stock to remain flat or decline, and hope to pocket the premium without any consequences.
Let’s use the same example as before. Imagine that stock XYZ is trading at $20 per share. You can sell a call on the stock with a $20 strike price for $2 with an expiration in eight months. One contract gives you $200, or ($2 * 100 shares).
Here’s the trader’s profit at expiration.
The payoff schedule here is exactly the opposite to that of the call buyer:
- For every price below the strike price of $20, the option expires completely worthless, and the call seller gets to keep the cash premium of $200.
- Between $20 and $22, the call seller still earns some of the premium, but not all.
- Above $22 per share, the call seller begins to lose money beyond the $200 premium received.
The appeal of selling calls is that you receive a cash premium upfront and do not have to lay out anything immediately. Then you wait until the stock reaches expiration. If the stock falls, stays flat, or even rises just a little, you’ll make money. However, you won’t be able to multiply your money in the same way as a call buyer. As a call seller, the most you’ll make is the premium.
While selling a call seems like it’s low risk – and it often is – it can be one of the most dangerous options strategies because of the potential for uncapped losses if the stock soars.
For example, if the stock doubled to $40 per share, the call seller would lose a net $1,800, or the $2,000 value of the option minus the $200 premium received. However, there are a number of safe call-selling strategies, such as the covered call, that could be utilized to help protect the seller.
While options can be risky, traders do have ways to use them sensibly. In fact, if they’re used correctly, options can limit risks while still allowing you to still profit from the gain or loss on a stock. Of course, if you still want to try for a home run, options also offer you that opportunity, too.