What Is a Call Option?
Introduction
A call option is an agreement that gives investors the right to purchase a stock from another investor or from the issuing company at an agreed-upon price by a particular date. Investors who buy call options are said to possess a “long position” in the stock; investors who sell call options are said to possess a “short position.”
Call options are a type of derivative and come in a variety of forms. Examples of these include leveraged call options, covered call options, and plain vanilla call options. In all cases, the underlying asset is an item, such as a security, commodity, or foreign exchange.
How Does a Call Option Work?
Call options provide the investor with the right, but not the obligation, to buy the underlying asset at a predetermined price on or before a specified date. This type of agreement entails three key elements: the underlying asset, the strike price and the expiration date. The underlying asset is the stock, commodity or index that the call option is linked to. The strike price is the price at which the investor may purchase the asset. The expiration date is the date after which the investor may no longer exercise the call option.
The value of the call option increases as the underlying stock’s price increases, and decreases as the underlying stock’s price decreases. Investors who buy call options are, therefore, betting that the stock’s price will increase. On the other hand, investors who sell call options are betting that the stock’s price will decrease.
What Is a Call Option?
A call option is a type of derivative security that provides the holder with the right, but not the obligation, to buy an underlying asset at a predetermined price — known as the strike price — on or before an agreed-upon expiration date. While call options are commonly used to speculate on the price of a specific asset, they can also be used to hedge existing investments or for speculative purposes.
Definition of a call option
A call option is a contract that gives the buyer the right, but not the obligation, to buy an underlying asset at a pre-agreed price, known as the strike price. This is accomplished by paying the seller, or “writer,” of the option a fee called a premium. The buyer of the call might be speculating that the underlying asset will increase in price on or before its expiration date, while the writer is hoping the opposite will occur.
How a call option works
When the buyer exercises their right to buy the underlying asset at the strike price, the writer is obligated to sell the asset at that price. If the market price of the underlying asset is higher than the strike price of the call option, the buyer can exercise their right to buy it at the strike price and then immediately sell it in the open market at a higher price, thereby locking in a profit.
The writer of the option, however, has a limited downside risk, because their maximum loss is the premium that was paid for the option. At the same time, the writer does not have the chance of infinite gains, as the stock price can only increase up to the strike price of the call.
Examples of call option trading
For example, if a trader buys a call option on ABC company’s stock at a strike price of $50, and the stock is currently trading at $55, the trader can execute the option to buy the stock at $50 and immediately sell it in the open market at $55, locking in a $5 profit. On the other hand, if the stock is trading at $40 when the option expires, the option will simply expire without any value.
Alternatively, a speculator might buy a call option on ABC company’s stock in anticipation that the stock will go up by the expiration date. If the stock rises above the strike price before the expiration date, the option will be “in the money” and the speculator will make a profit; however, if the stock does not rise before the expiration date, the option will expire and the speculator will lose their premium.
Advantages of a Call Option
A call option is a type of financial instrument that gives an investor the right, but not the obligation, to buy shares of a stock at a predetermined price, or strike price, on or before the designated expiration date. There are several advantages to investing in call options that make them attractive to certain types of investors.
Reduced Risk to Investors
Investing in call options allows investors to gain exposure to a particular stock without having to put up the entire cost of buying the stock outright. Call options offer more limited risk than buying the stock because the maximum you can lose when you purchase a call option is the price you pay for the premium. With this limited risk, investors can potentially make a greater return than the potential cost of the option.
Ability to Leverage Stock and Create Upside Potential
Investing in call options gives investors the ability to leverage their stock. By leveraging stock, investors are able to maximize their potential upside return while minimizing their risk. This is because when purchasing a call option, an investor needs to put up only a small portion of the full cost of buying the underlying stock.
Tax Advantages
For investors in some tax brackets, investing in call options may also offer tax advantages over buying the stock outright. Depending on the individual investor's situation, the taxes due on profits earned from selling a call option may be lower than the taxes due on profits earned from selling the stock. The individual investor should always check with a qualified tax advisor to determine the tax consequences of their investments.
Disadvantages of a Call Option
Call options are powerful trading tools, however they come with some drawbacks. Before investing in call options, investors should weigh these potential drawbacks carefully.
Limited Profits
Although investors can make substantial gains from trading call options, there is also a limited profit potential. When trading call options, investors can only make a certain amount of money from each contract before the option expires, no matter what the market does. Therefore, call options rarely reach the potential maximum profits.
Uncertainty of Stock Prices
Call options are highly dependent on the fluctuations of stock prices. No matter how experienced or knowledgeable an investor is, it is impossible to predict what will happen with a stock's price in the future. Therefore, investing in call options inherently involves significant uncertainty as stock prices may go against the expected direction, leading to losses even under the most ideal circumstances.
Expenses Associated with Trading Call Options
In addition to the money invested in the contracts, making a call option trade also involves the costs of brokerage commissions. These commissions can add up quickly since most call option strategies require multiple trades and contracts. Furthermore, all profits are reduced by the costs associated with trading call options.
- Limited profits
- Uncertainty of stock prices
- Expenses associated with trading call options
Steps to Trade a Call Option
Trading a call option involves several steps, including researching the stock, analyzing its underlying market, determining the potential value of the option contract, and purchase the agreement. These steps provide traders with the information necessary to craft a profitable strategy from their options trading.
Choose a Stock
To trade a call option, first choose the assets you would like to invest in, such as a single stock, an ETF, or a mutual fund. Many traders select stocks from the larger index such as the S&P 500 or the Dow Jones Industrial Average, but the list of options for trading call options is quite extensive. Investigate each stock by reading analyst reports, researching the company and its industry, and utilizing trading tools. This will help to ensure that you select a stock that is trending favorably in the markets, as well as one that has the potential for long-term growth.
Monitor Pricing and Trends
After selecting your asset, monitor the pricing and trends of the stock over the short-term and the long-term. Analyzing the stock’s performance in the markets is extremely important, as it can provide insight into whether the stock is poised to increase or decrease in value. Utilize trading tools, charting services, and analyst reports to gain insight into the asset’s performance and whether it may be a good choice for trading call options.
Research the Company
In addition to analyzing the stock, research the underlying company, including its financial statements, management team, and any major events that could influence its performance. Pay close attention to the company’s news announcements and the performance of its competitors. This can help you determine whether the company is likely to increase or decrease in value and will give you the information that you need to make an informed and profitable decisions.
Calculate the Value of the Contract
Once you’ve done your research and chosen a stock, you can then calculate the potential value of the call option contract. An option’s theoretical value is based on a variety of factors, including the option’s strike price, current market conditions, implied volatility, and the underlying stock’s volatility. Use a call option calculator or a trading platform to determine the option’s theoretical value. Knowing the theoretical value of the option will allow you to place the right order, thereby maximizing your gains.
Purchase the Option
The final step for trading a call option is to purchase the option. When you purchase the option, it must be done through a brokerage account. You can place a live order through a broker or you can use a trading platform to simulate the trade. When placing the order, be sure to specify the number of contracts that you are purchasing, the expiration date of the option, and the strike price at which you would like to buy the contract.
Risks Involved with Trading a Call Option
It is important to keep in mind that trading call options comes with some risk. All investors should be aware of the potential benefits and risks associated with options trading. Here are some of the risks to consider when trading call options:
Market Risk
One of the primary risks associated with trading a call option is market risk. This is the risk of the underlying stock falling in price and the call option expiring worthless. If the stock does not reach the strike price by the expiration date, the option will expire and the investor will lose the premium they paid for the option.
Volatility Risk
Volatility can also be a significant source of risk when trading options. As the volatility of the underlying stock increases, so does the premium of the option. If the stock is too volatile, then the option could become too expensive for the investor to buy. On the other hand, if the stock is not volatile enough, then the option won't be worth buying in the first place.
Time Risk
Another risk associated with options trading is time risk. This is the risk that the underlying stock won't reach the strike price before the option expires. If this happens, then the investor would lose all the money they paid for the option. The time premium of an option decreases as the option approaches its expiration date, so it is important to be aware of how much time is left until the option expires.
Conclusion
A call option is a type of financial derivative contract that gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price on or before a specified date. The holder of the call option can choose to exercise the right or not, depending on the underlying asset’s market price. Call options offer several advantages, including the ability to take a position with reduced risk, to benefit from price appreciation, and to limit losses. There are also several risks to consider when trading a call option, including the possibility of assignment and the risk of market losses due to expiration.
Trading a call option involves a few steps. First, potential traders should select a call option and assess the underlying asset. They must then decide the number of contracts to buy, the price, and the expiration date. Finally, they can place the order with their broker of choice. As with any trading activity, potential traders should understand the risks associated with trading a call option before entering a position.
Call options offer several advantages to traders, but it is also important to understand the risks. By taking the time to understand call options and familiarize themselves with the process of trading them, traders can use them to potentially benefit their portfolios.