What is a Call Option?

A call option is a commonly utilized derivative contract between a buyer and a seller. It provides the buyer with the right to purchase a specific asset at a certain price within a certain time period. Here's a look at call options.

what is a call option

A call option is a contract that gives a buyer the right to buy an asset by a certain date. The buyer isn’t obligated to buy the asset, but has the choice – or option – to purchase the asset, if certain conditions are met. The seller (known as the call writer), on the other hand, is obligated to sell the asset if the buyer chooses to exercise his rights. Call stock options are commonly used with stocks, but can also be used with bonds and other assets.

Parts of a Call Stock Option

The call option has several components. The stock option premium is the amount the buyer pays for the option. The expiration date is the date by which the option must be exercised before it becomes void. Once the option expires, the option buyer loses the right to purchase the option at the previously negotiated price. The strike price is the price at which the asset can be purchased before the expiration date. The option premium takes into account four different factors: the current stock price, the amount of time until the option expires, the volatility of the market, and the strike price. The intrinsic value of the option is the difference between the stock’s price and the strike price.

Making Money With Call Options

A call option is in-the-money when the current price of the asset is above the strike price. For example, if a stock’s strike price is $40 and the stock’s current price is $45, then the call would be in-the-money. (The intrinsic value is $5 in this example.) A call option is out-of-the-money when the stock price falls below the strike price. The option isn’t profitable if the stock price doesn’t rise above the strike price. It’s worthless if the stock price falls below the strike price. If the option becomes worthless, the seller isn’t obligated to comply with the contract.

Why Purchase Call Options?

The call writer initially makes money when the call optionis sold. But, the buyer purchases a call option hoping the value of the stock goes up before the option expires. This gives the buyer the opportunity to purchase the stock at a lower price, sell it at a higher price, and make a profit.

Buyers don’t always have to sell the underlying stock to make money. Instead, the buyer can sell the call option itself, which increases in value as the stock price increases, and make a profit. The opposite of a put option. However, if the stock value doesn’t go up or it drops, the buyer loses the money he paid for the option premium.

The call writer, on the other hand, hopes the stock price doesn’t rise before the option expires. In that case, the call writer keeps the contract premium as profit. But, the call writer loses money if the stock price rises and the buyer exercises his call option.

For example, assume a buyer pays a $200 call premium to purchase 100 shares of stock at $40 by April 21. (Note: one stock option is 100 shares of stock.) The stock price rises to $45 on April 10 and the buyer chooses to trade out his position. If the call writer doesn’t already own the stock, he must purchase 100 shares of the stock at $45 ($4,500) and sell them for $40 each ($4,000) taking a $300 loss (after the $200 received premium).

If the call buyer sells the stock for $4,500 after purchasing it for $4,000, he’d receive a $300 gain (after the $200 premium).

But, if the stock price dropped to $38, the option becomes worthless and the buyer loses the $200 option premium he paid. The call writer, on the other hand, is $200 richer.

Options investing involves risk and is not suitable for all investors. It is possible for an options investor to lose the entire amount committed to options in a relatively short period of time. Copies of the Options Disclosure Document are available upon request by calling your representative or by contacting the Options Clearing Corporation at 1-800-678-4667. You may also visit their website www.theocc.com.