Investing > Call Option Explained

Call Option Explained

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

One of the main attractions of trading in options is the versatility it provides. Call options are a crucial part of this equation, as they help investors to both manage risk and create leverage.

When retail investors want to give their portfolios a boost, but don’t want the risk borrowing money attracts, they usually look to options  — specifically call options to get this benefit.

However, many investors keep options trading at an arm’s length due to its reputation of being too complex. But the options strategies a trader employs can be as simple or as complex as they want them to be.

For those who want to dip their toes into the waters of call options trading, the simplest way to do so is by buying call options. Many novice investors follow this route, not only because of its simplicity but because successful call option trades generate huge ROI (return on investment).

While the focus of this article is on call options trading, a broader understanding of options trading will be beneficial in digesting the content here. So without further ado, let’s start by examining what constitutes a call option

What is a Call Option?

Call options provide an investor with the right, unbound by any obligation, to buy an asset at a certain price. This asset can be any type of security ranging from stocks, shares, bonds, commodities, or any other financial instrument. 

Options don’t have any intrinsic value, but derive their value from their underlying asset; hence, they are called financial derivatives. Unlike stocks, options don’t have any ownership of the shares that underlie them. 

Although options are contracts, a call option isn’t an obligation to purchase a stock or security. The contract only permits the call option buyer to purchase the stock at a specified price within a certain time duration.

In options trading parlance, exercising the call option simply means buying the underlying security.

While a call option allows an investor to buy a stock at a predetermined price, this sell option does the opposite: allowing an investor to sell their stock at a pre-set price. However, what they both share in common is their transactions must be completed before a pre-set expiration date.

The call option’s specified price to buy the stock is known as the strike price, while the date by which the purchase has to be made is known as the time to maturity; or more succinctly, the expiration date.

There are some differences between the U.S. and European-style options. While U.S.-style options allow the buyer to purchase the options anytime on or before the expiration date, European-style options can only be exercised on the exact expiration date.

How does a Call Option Work?

An option is an open contract which means the trader is not required to buy or sell the security.

A call option usually involves the right to buy shares of the stock for each contract (usually in 100 share units), which can be purchased at a pre-negotiated price (the strike price) and before a certain date expires (expiration date).

Instead of boring you with technical jargon of how a call option works, an illustration will go much further in depicting how it operates.

An appropriate analogy to call options which most of us can understand or relate to is the process of purchasing a home. 

With a brief rundown, we’ll illustrate what happens when two different scenarios occur: when a buyer purchases a home, or when she doesn’t buy the home.

Then, we’ll tie it all together into how call options work. Terms pertinent to call options are highlighted to underscore their correlation with the subject matter.

After finding a home she is interested in, the buyer negotiates and agrees with the seller of the house on a purchase price. To show the buyer is serious about making the purchase, she’ll be requested to make a down payment. A down payment is a fraction of the total price, usually 5% or 10%. 

After making the down payment, the buyer receives the right  — not an obligation  — to purchase the home. Conversely, by accepting the down payment, the seller is now obligated to sell the house to the buyer at the agreed price, as long as it is before a specified date after which the deal will expire

If for some reason, the buyer is unable to buy the home, she’ll lose her down payment. 

In the preceding illustration, the house buyer and seller represent the call option buyer and call option seller respectively.

Likewise, the house is equivalent to the security (stock, bond, or commodity) a trader wants to buy by placing a call option on it. The house down payment is similar to the premium the call option buyer pays for the right to exercise the option any period until its expiration date . The agreed house purchase price is comparable to the call option strike price .

Just as the home buyer reserved the house by placing a down payment, a call buyer reserves the right to buy a stock at a set price by purchasing option calls. A call seller (also known as the call writer), sells the price reservation. In the form of a call option 

A call option buyer isn’t under any obligation to exercise the option, but once she does, the call option seller must turn over the shares at the point of exercises, even if those shares are trading at a higher value than the strike price.  

What does the Call option buyer get and at what cost?

When the call option buyer pays the premium, she reserves the right to purchase a stock at the strike price for a period of time. The call option will only be worth money if and when the price of the underlying security moves above the strike price. 

When that happens, the call option is said to have intrinsic value. 

When the stock price reaches or exceeds the strike price, the call option buyer has two options available. She can sell the option for a profit  — which is usually the default action most call option buyers take.

Or, she can exercise the option at the expiry and thus receive the shares.

However, if the stock price never reaches the strike price and the expiration date passes, the call option buyer loses the premium paid.

What does the Call option seller get and at what cost?

Writing call options is a means of generating income. However, call option writers have different motivations from call option buyers. The call option seller (or writer) gets to keep the premium deposited by the call options buyer if the strike price isn’t attained. 

As opposed to the buyer who wants the stock price of the underlying asset to rise above the strike price, the call option seller operates in the hope that the price of the asset will decline. Or at the least never rise to the level of the strike price. 

Consequently, call options sellers keep their fingers crossed in the hope that the call option expires because it is only under those conditions that they get to keep the premium.

Also, call option writers have less latitude in the amount of income they can generate for themselves. While the call option buyer’s income is potentially unlimited, the seller’s revenue is only limited to the premium received.

What does it mean to buy a call option?

A call option means that you are betting on the direction of the market. It is an indication that you expect the price of a stock will go above the strike price. 

If an investor is bullish on the market, especially for a particular stock, a call option is a way to profit from the insight. Buying a call option means that an investor wants to give themselves exposure to the upside of the stock.

Options also provide a means from protecting against market risk. Therefore, buying a call option can also indicate that the investor wishes to shield themselves and minimizes their losses from decline in the value of their stock portfolio.

How do you calculate a call option’s cost?

Calculating call option costs is straightforward if you follow the syllogism of the process: 

The rule of thumb is that one call option contract is represented by 100 shares of the underlying stock. Also, the call option prices are usually quoted per share of the underlying stock. 

So, to calculate the amount of money buying a call option contract will cost, you simply multiply the price of the option by 100.

How do you profit from a call option?

To illustrate how to profit from an option call, we’ll contrast what happens when an investor buys stock as opposed to a call option.

Thinking hypothetical, if a stock like, say, McDonald’s is trading at $30, but you think it is currently undervalued and therefore expect its price to go up. Perhaps this belief is predicated on the notion that their stock will rise sharply after their earnings report comes out in a few weeks.

A savvy investor might decide to buy the stock directly in anticipation of when the price will increase so she can make a profit. Let’s assume you decide to buy 100 shares. That would cost you $3,000, excluding brokerage fees. 

On the other hand, the smart investor that you are might decide to go the call options route instead. So you choose to buy a call option priced at $2 per share, with a strike price of $40 which expires in two month’s time.

So, how does this work out in financial terms?

Generally, option contracts are facilitated in hundreds of shares; usually bought in rounds of lots or 100 share lots. So if you decide to buy 100 McDonald’s shares, that is equivalent to a one call option contract (assuming 100 shares equals one option contract). 

Therefore, you’ll need to fork out $200 plus brokerage for a one call option contract (100 shares times $2 per share). In call trading terms, you paid $200 to purchase a single $40 McDonald’s call option covering 100 shares.

However, if you decided to buy the stock outrightly as an investor, you would be forced to come up with $3,000 upfront. If the McDonald’s stock reaches $50, investors who bought the stock at $30 will make $2,000 in profit, which represents a 67% increase. 

On the other hand, if you decided to trade on option calls, purchasing a call option at $40 instead of outrightly buying McDonald shares at $30, you spent only $200. As the price of the McDonald’s stocks jumped to $50, the call option buyer can exercise the right to buy 100 shares of the stock at $40. 

In this scenario, the call option buyer will make a profit of $800 (the total stock increase amount  of $1,000 minus the premium paid amount of $200)  from only a $200 investment, an astonishing gain of 400%

While this sounds tantalizingly good, consider also what happens if the opposite occurs. Your risk is lessened with options trading in the event the stock price drops. So, still following the preceding example, let’s assume the McDonald’s stock price fell to $20 instead. 

The investor who bought the stock at  $30 will lose $1,000, which represents a 33.3% loss. On the other hand, since a call options trader isn’t obligated to buy the stock at $40, you only lose your initial investment of $200 premium.

Although this is evidently a 100% loss, it nonetheless represents a fraction of what the amount could have otherwise been. 

Evidently, the commission fees the trader will have to pay weren’t factored into our calculations. In addition, these commissions vary across as options brokerages. Just be aware that commissions can eat significantly into the profits of active traders, especially in the long term. 

Therefore, if you trade options on an active basis, it will behoove you to find a low commission but reputable brokerage. To give you a head start, you can check out our review of the best options brokerages in 2020.

Can you lose money on a call option?

The short answer is yes, you can lose money on a call option.

Like any business or investment venture, the potential for loss is always possible. Call option trades come with their limitations, which doesn’t always make them the better deal to pursue in some circumstances. For instance, it contains some inbuilt volatility as the value of the option’s contract fluctuates depending on the price gyrations of the underlying asset.

To make money on a call option, the stock price has to rise and at least meet the exercise or strike price. In our preceding example, this is $5.40. From the perspective of the call option buyer, the option can only have underlying or “intrinsic” value when it reaches the strike price.

And once you place an option bet, you are in a race against time. This is because the value of an option contract is also predicated on the amount of time remaining before the option expires. This in turn influences the price a buyer is willing to pay (the premium) for the option.

Based on the money generated  — or lack thereof, an option can be in three situations or phases:

It could be in the money (ITM), it could be out of the money (OTM), or alternatively, at the money (ATM).

In the Money (ITM)

An option contract is said to be in the money (ITM) when the price of the underlying asset is more than the strike price. At this point, the option is said to have intrinsic value. 

In our made-up example, when the McDonald’s shares, which is the underlying stock, start to trade at $50, the option contract is in the money (ITM) since it is above the strike price of $40. The higher the stock rises above $50, the more ITM and intrinsic value it has.

Out of the Money (ITM)

When the price of the security used in the call option doesn’t rise above the strike price prior to the expiration date, it would no longer be profitable for the buyer to exercise the call option because she will “under the water” so to say. 

It would be foolhardy to exercise the right to buy the stock since the call option buyer would be paying for more than its current value. 

Consequently, the option is said to be “out-of-the-money” usually expiring worthless. 

At the Money (ATM)

But what happens when the intrinsic value of a call option is zero? Well, that means the strike price is the same as the price of the underlying stock, so there isn’t any net gain. The option is ATM when McDonald’s shares rise to $40, the same as the strike price of $40 and therefore cannot be exercised for profit.

Why would someone buy a call option?

Simply stated, to manage risk and gain leverage. 

The attractiveness of the call option is that while it potentially offers some similar upside of owning stock, its downside risk is much more limited. The vagaries of the stock market are that stocks can drop precipitously all the way down to zero, unleashing monetary losses and financial shock on investors. 

While call options can suffer the same fate and lose all its value  — this happens more frequently with options than with stocks, given the way they are structured  — yet there is more leeway with options since you have an exit ramp that allows you to mitigate those losses.

This is because you can choose the strike price of the option you buy and decide whether you want to exercise the call option or not. This ultimately gives the trader more control over the amount of money they risk.

Moreover, the cost of the call option is usually far less than you would normally pay for shares. Which brings us to the speculative aspect of call options.

Leverage and Speculation

Call options are leveraged investments. 

Purchasing options gives a call option buyer the opportunity to invest a small amount of money and potentially reap a disproportionate profit from the capital investment due to a rise in the underlying security’s price.

Call options have the promise of providing potentially unlimited profits while also managing to limit losses incurred (limited to the premium paid for the option). 

They provide much more leverage than buying shares. 

Remember our McDonald’s example where the call option buyer gained a 400% profit increase just by investing $200! 

Call options are bought by entities with different motivations spanning the small, individual investor to the behemoth corporate and institutional investor. 

Investors use call options for other reasons too, such as hedging.

Hedging their investments

Apart from the obvious incentive to maximize profits, both individual investors and large corporations like investment banks often use call options hedge away from the positional risks associated with holding unto an asset or security for a significant period of time. 

Mostly adopted by larger investors who use call options as a way to hedge their stock portfolios and increase their marginal revenues. The holding position may vary from a couple of weeks to several years. 

Hedging with an option is like an insurance policy. It usually works by placing your call option opposite the position of the underlying stock or security. The intent is to reduce or limit the number of potential losses from the stock in the event of a market downturn or unforeseen circumstances. 

The versatility of call options are such that they can be bought, then used to hedge short stock portfolios. Call options can also be sold to hedge against a pullback with regard to a long stock portfolio. 

In summary, these are the main reasons why people and institutions buy option calls:

  • In order to eventually buy the stock outright when you can benefit from the rise in its stock price.
  • To be in a position to buy a stock at a lower price.
  • Protect and safeguard your stock portfolio from a marketplace decline.
  • Increase and boost your income against the stock holdings currently held.

The long call options strategy

This is the most basic options strategy. It occurs when traders buy call options in the hope that the underlying stock will rise past the strike price before the option expires. 

Some of the reasons long call option strategy prove to be advantageous to the investor are these:

Long call options provide leverage

The long call option gives the buyer more leverage than they would have otherwise gained buying the underlying shares outright. This is because for every point the price of the underlying stock rises, the lower-priced call options generally appreciate and rise faster in percentage value.

Nevertheless, call options have a limited lifespan, and therein lies the risk. The long call option becomes worthless if the underlying stock doesn’t rise beyond the strike rate before the expiration date lapses. 

Long call options potentially provide unlimited profit

Theoretically, stocks are capable of rising limitlessly. In that vein, there are equally no limits to how high the underlying stock can rise before its long call option expiration date. Therefore, the profits that can be gained from implementing a long call option strategy are potentially boundless.

Can you sell a call option early?

Yes, you can sell a call option early. This is called the early exercise of an option contract. An early exercise of an option contract involves either buying or selling (it could be either a call or put option) shares of the stock before its expiration date.

To sell a call option early, the call option buyer demands that the call option writer sell the underlying stock shares at the agreed-upon strike price. It should be noted that this is only possible with the U.S.-style option contracts because it allows the call option holder to exercise the contract at any time before the expiration date.

For long call options, the investor closes the trade by selling the option instead of exercising it.  They profit from the difference between the current selling price of the stock (strike price) and the original purchase price.

We have mentioned how a call option has intrinsic value when it is in the money (ITM). Another pillar of value an option wields is its time value. The more time that remains before a call option expires, the more time value it has. 

The profit from an early call option is predicated on the time value of the option. When an early call option is exercised, it automatically eliminates the time value.

Conclusion

Call options are like the swiss army knife of investment instruments. They are multilayered and able to adapt to the simplicity or complexity of your investment strategy.

While we mainly focused on the use of call options with stock holdings (since that is the security most people are acquainted with), they can be used on a diversity of instruments such index, futures, and ETF options.

When deftly deployed, they can provide the trader with often needed leverage, enabling a trader to punch above their weight by profiting significantly from an increase in the underlying stock while paying only a fraction of the cost.

But this is a double-edged sword, as high degrees of leverage are one of the main reasons options calls are considered to be high-risk investments.

One of the underrated superpowers of options is that they help an investor by becoming a crucial part of a larger investment strategy, ranging from minimizing risks, hedging away from positional risks, maximizing investment profits, and buying stock at a cheaper rate.

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

Cookies & Privacy

TheTokenist.io uses cookies to provide you with a great experience and enables you to enjoy all the functionality of the site.