Market swings are unavoidable and unpredictable. Even with a bullish market sentiment, it is crucial to manage risk. To that extent, there are financial avenues that help in mitigating risks. One such avenue is call options.
Call options give buyers the right (but not the obligation) to buy an underlying asset at a pre-specified price. In this article, we will discuss call options in further detail and understand how they work. The Options Clearing Corporations offers a helpful document that discusses the characteristics and risks of options, which can be found on their website.
What is a call option?
A call option is a financial tool that enables you to buy a specific asset at a predetermined price within a stipulated period. It gives you the right to purchase an asset without the obligation to do so. Because the value of a call option is derived from another security, they fall in the category of financial products known as derivatives.
When you purchase a call option, you are essentially securing the ability to purchase the asset at a later date (known as the expiration date) at a set price (called the strike price). This is an options strategy to have the ability to buy at a predetermined price when buyers expect a rise in the asset price.
If the asset price at expiration surpasses the strike price, the option is considered in the money and has intrinsic value, which is the difference between the asset’s current price and the strike price. If the asset’s price remains below the strike price or doesn’t rise significantly, the option is considered out of the money and lacks intrinsic value.
You have to pay a premium while purchasing a call option. It is the cost of the option, which is influenced by various factors such as the current market price of the asset, the strike price, the time to expiration, market volatility, and interest rates.
In the US, options exchanges such as the Chicago Board Options Exchange and the Options Clearing Corporation are responsible for call options trading. Options traders can use standardized call options trading on different assets such as stocks, indices, and exchange-traded funds (ETFs). Individual investors, institutional investors, and hedge funds can all invest in call options.
How do call options work?
A call option works by hedging your investment in favor of increasing asset prices. It provides you an option to buy the asset at a predetermined price without an obligation to do so.
Here's how a call option works in simple steps:
Step 1: Purchase the call option for a specific asset.
Step 2: Pay a premium to the option seller, also called the option writer.
Step 3: Gain the right but not the obligation to exercise the option.
Step 4: If the asset’s price surpasses the strike price before the option expires, exercise the option to buy the asset at the predetermined price. You profit by being able to purchase the asset at a lower price than its market value
Step 5: If the asset’s price fails to exceed the strike price or you choose not to exercise the option, let it expire. In this case, you do not make a profit and lose the premium paid.
When can you exercise call option?
Let’s see the scenarios below to understand what happens when the stock price goes up or down.
Scenario 1: The stock price goes up: If the stock price rises to, let’s say, $120 per share, you can exercise your call option. That means you can buy company Xs shares at the strike price of $110 strike price even though they’re worth $120 in the market. Your profit from this options trade is $120 – $110 – $5 (premium) = $5 per share.
Scenario 2: The stock price goes down: If the stock price drops below the strike price of $110, you don’t have to exercise the option. In this case, you’re not obligated to buy the shares, but you lose the $5 premium per share you paid for the call option.
Long vs. Short call options
Call options are essentially an agreement between a buyer and a seller. They are viable only when the two have opposite expectations about the direction in which the price of an asset will move over a given period. That is the fundamental difference between a long call and a short call in options trading.
Long call:
A long call represents a buyers bullish approach to the price of a security. It is bought assuming the assets price will rise beyond the strike price. The buyer then makes a profit by buying an asset at a price lower than its current market value.
The most significant risk with long call options is the potential to lose the entire amount invested. If the price of the underlying asset does not exceed the strike price by the expiration date, the option will expire worthless.
Short call:
A short call reflects a sellers bullish sentiment regarding the price of an asset. Its based on the expectation that the assets price will fall below the strike price by the expiration date. The seller then makes a profit from the premium paid by the buyer while also getting to keep the stocks they declined to buy.
The primary risk of a short call option is potentially unlimited losses. If the price of the underlying asset rises above the strike price, the option seller is obliged to deliver the shares at the strike price, no matter how high the market price of the asset may be.
Short Call Option
Long Call Option
Market View
Bearish
Bullish
Anticipation
Decrease in underlying asset price
Increase in underlying asset price
Primary Advantage
Potential to generate income through upfront premium received from the buyer
Potential for significant profits through price appreciation of the underlying asset
Primary Disadvantage
Unlimited potential for losses if the price of the underlying asset rises significantly.
Risk of losing the premium paid if the price of the underlying asset does not rise above the strike price before the option expires
Long and short call options are two distinct types of trading strategies. They require careful assessment of your objectives and risk tolerance, besides thorough research on the underlying asset, market conditions, and option pricing.
How to calculate call options profit?
To calculate the profit of a call option, you need to consider the purchase price of the option, the strike price, the current price of the underlying asset, and the premium paid at the time of the transaction. You can calculate the profit by determining the difference between the market price of the underlying asset and the strike price. You need to adjust the final amount against the premium paid and transaction costs, if any.
Lets understand it better with an example:
Let’s say you purchase a call option on the stock of Company A at the strike price of $50. The current market price of the stock is $55, while the premium you pay for the option is $3 per share.
If the stock price rises to $60 before the option expires, you can exercise the option and buy the stock at the strike price of $50. By selling the stock at the market price of $60, you make a profit of $10 per share.
To calculate the overall profit, you deduct the option premium ($3) and any transaction costs from the profit per share. If, for instance, the transaction costs are $1 per share, your net profit would be $6 ($10 – $3 – $1) per share.
On the other hand, if the stock price does not reach the strike price of $50 before the option expires, the call option will not be exercised, and you would incur a loss equal to the premium paid, which in this case would be $3 per share.
Why are key uses for call options?
Call options generally work as an investment strategy, and they have the following key uses:
1. Using covered calls for additional income
In the covered calls options strategy, investors already own shares of stock (typically 100 shares per option contract), and they can sell call options against those shares. Premiums from the option buyers may become income for investors. If the stock price remains below the strike price, the options expire, and investors retain both the premium and shares.
This strategy may generate a steady income while maintaining ownership of underlying assets. The challenge with this strategy is that the covered call writer might miss out on potential stock gains beyond the strike price if the option gets exercised.
2. Using calls for speculation
Call options can act as a speculative tool when investors options trading strategy is to limit risk even when they have a bullish market view. Call options offer an opportunity to buy options at a fraction of assets cost, without purchasing the asset directly. If the assets price rises above strike price, investors may gain substantially at a relatively lower initial price.
Why buy a call option?
Investors may generally buy call options when they are optimistic about the financial market. Here are the primary scenarios where investors generally consider buying:
Anticipation of a rise in stock prices.
Wish to limit downside risk.
Potential to capitalize on short-term share price fluctuations.
Exposure to a particular industry without needing to buy individual stocks.
Why sell a call option?
Selling a call option may be a strategic choice when investors have a neutral to bullish market position. If you exercise an option, you must sell the underlying asset at the strike price.
Here are the key circumstances where investors consider selling:
Anticipation of stock prices to remain the same or go down.
An objective of generating a steady income.
An objective of hedging against an existing long stock position to offset potential losses in the stock price decreases.
An intent of reducing position in a particular stock, sector, or industry and lock in potential gains.
Leverage call options strategically
Call options may be lucrative financial instruments when traded strategically. You must, however, have a thorough understanding of the market and current trends before you start investing.
Frequently asked questions
What's the difference between buying a call option vs. owning the stock?
Owning the stock means you purchased the shares of a company. Buying a call option means you can purchase a particular stock at a pre-specified price without the obligation to do so.
Can you exercise a call option without funds?
No, exercising a call option requires funds, as you need to buy the stock at the predetermined price. If you are out of funds, you can sell the option before the expiry date.
How to write covered calls and sell put options?
To write covered call options, you can sell call options of the stock that you already own. Selling put options means that you sell the right to sell the stock at a predetermined price.
What happens when call options expire?
An expired call option is worthless if they are out of money. In that case, you lose the money paid as a premium and do not make any profit. If your options are in the money, your broker can automatically exercise it to make you a profit.
What is the formula to calculate profit on a call option?
Profit on a call option is calculated as the difference between the stock’s current price and the strike price minus the premium paid for the option. You will also need to consider the stock size while calculating profit. Many online trading platforms have integrated options for profit calculators.
How to exercise a call option?
To exercise a call option, you will need to notify your broker. Your broker will facilitate the process, and if the option is in the money before the date of expiry, you’ll be required to pay the strike price per share to acquire the underlying stock.
How to close a call option?
To close a call option, you can sell it back to the market before it expires. By selling the option, you may realize any profits or limit your losses depending on the difference between the strike price and the actual stock price at the time of closing the option.
