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.
- Why use options?
Options are more advanced tools that can help investors limit risk, increase income, and plan ahead.
What are call options?
- A call option is a contract between a buyer and a seller to purchase a certain stock at a certain price up until a defined expiration date. The buyer of a call has the right, not the obligation, to exercise the call and purchase the stocks. On the other hand, the seller of the call has the obligation and not the right to deliver the stock if assigned by the buyer.
- For instance, 1 ABC 110 call option gives the owner the right to buy 100 ABC Inc. shares for $110 each (that's the strike price), regardless of the market price of ABC shares, until the option's expiration date.
- Suppose ABC shares are trading at $100 today the owner of the ABC 110 call option hopes shares rise above $110 any appreciation above that represents the potential payout. If you exercise the call when shares trade at $120, then you buy 100 ABC shares for $110 and voila your return is $10 per share for a total gain of $1,000.
- But all that fun isn't free. A call buyer must pay the seller a premium: for example, a price of $3 per share. Since the ABC 110 call option then costs $300 and paid out $1,000, the net return is $700.
- These examples do not include any commissions or fees that may be incurred, as well as tax implications.
How a call option works
- 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 before it expires.
- A call owner profits when the premium paid is less than the difference between the stock price and the strike price at expiration. For example, imagine a trader bought a call for $0.50 with a strike price of $20, and the stock is $23 at expiration. The option is worth $3 (the $23 stock price minus the $20 strike price) and the trader has made a profit of $2.50 ($3 minus the cost of $0.50).
- 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.
A long call: speculation or planning ahead
- A "long call" is a purchased call option with an open right to buy shares. The buyer with the "long call position" paid for the right to buy shares in the underlying stock at the strike price and costs a fraction of the underlying stock price and has upside potential value (if the stock price of the underlying stock increases).
- A long call can be used for speculation. For example, take companies that have product launches occurring around the same time every year. You could speculate by purchasing a call if you think the stock price will appreciate after the launch.
- A long call can also help you plan ahead. For example, you may have an upcoming bonus that you would like to invest in a stock today, but what if it didn't pay out until the following month? To plan ahead and lock in the price of the stock today, you could purchase a long call with the intent to exercise your right to purchase the shares once you receive your bonus.
A short call: boosting income
- A "short call" is the open obligation to sell shares. The seller of a call with the "short call position" received payment for the call but is obligated to sell shares of the underlying stock at the strike price of the call until the expiration date. A short call is used to create income: The investor earns the premium but has upside risk (if the underlying stock price rises above the strike price).
- Both new and seasoned investors will use short calls to boost their income but, more often than not, do so when the call is "covered." So in case you are assigned, you are simply selling stock that you already own.
- An "uncovered" call carries significantly more risk and a potential for unlimited losses because you are obligated to find shares to sell to the call purchaser. Imagine if you had to buy shares which were 20% more expensive than the price you are selling them for. Yikes!
Assignment of a short call
- A short call investor hopes the price of the underlying stock does not rise above the strike price. If it does, the long call investor might exercise the call and create an "assignment." An assignment can occur on any business day before the expiration date. If it does, the short call investor must sell shares at the exercise price.
- Remember, the call is "covered" if you sell shares you already own but, if it's "uncovered," you must find shares to sell to the call purchaser.