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, how they work and more.
Call options are a type of financial derivative that give investors the right, but not the obligation, to purchase a stock or another asset at a specific price (called the “strike price”) within a certain period. Call options are popular among investors who believe the price of a stock will increase, allowing them to buy it at a lower price and potentially make a profit.
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.
Before diving into how call options work, it’s essential to understand the key components:
This is the security or stock that the call option is based on. Commonly, call options are written on individual stocks, but they can also be tied to ETFs, commodities, or indexes.
The price at which the buyer of the call option can purchase the underlying asset. This price is predetermined when the option contract is created.
The call option has a set period during which it can be exercised. After the expiration date, the option becomes worthless.
This is the price paid by the buyer to the seller (also called the option writer) for the rights conveyed by the option. It’s essentially the cost of entering into the option contract.
In most cases, each options contract controls 100 shares of the underlying asset.
To understand call options, let’s break down their core components:
Suppose XYZ company is trading at $110 at expiration, and the strike price for a call option contract (which represents 100 shares) is $100. The option cost the buyer $2 per share. To calculate the profit:
Profit = $110 – ($100 + $2) = $8 per share.
If the buyer purchased one options contract, their total profit would be $800 ($8 per share × 100 shares). If they bought two contracts, their profit would be $1,600 ($8 per share × 200 shares).
However, if XYZ company is trading below $100 at expiration, the buyer won’t exercise the option, as it wouldn’t be beneficial to buy the shares at $100 each. In this case, the option expires worthless, and the buyer loses the $2 per share premium or $200 for each contract purchased. The beauty of buying the call options is that the maximum loss is limited to the premium paid.
Now, consider that you own 100 shares of XYZ company, which are currently trading at $108 per share, and you want to generate extra income on top of the stock’s dividend. You believe the share price won’t rise above $115 in the next month.
You check the call options and find a $115 call trading at $0.37 per contract. By selling one call option, you collect a $37 premium ($0.37 × 100 shares), which represents approximately a 4% annualized income.
If the stock price rises above $115, the option buyer will exercise the call, and you’ll be required to sell your 100 shares at $115 per share. You’ll still make a profit of $7 per share, but you’ll miss out on any additional gains above $115. If the stock remains below $115, you keep both the shares and the $37 premium income.
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.
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 X’s 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.
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.
A long call represents a buyer’s bullish approach to the price of a security. It is bought assuming the asset’s 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.
A short call reflects a seller’s bullish sentiment regarding the price of an asset. It’s based on the expectation that the asset’s 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.
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.
Let’s 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.
At expiration, look at the current market price (also called the “spot price”) of the underlying asset.
The intrinsic value of a call option is the difference between the underlying asset’s market price and the strike price, but only if the asset’s price is above the strike price.
If the asset’s price is below the strike price, the intrinsic value is zero, and the option expires worthless.
Formula:
Intrinsic Value = Market Price – Strike Price
Example:
If the strike price is $50 and the asset’s market price is $60, the intrinsic value is $60 – $50 = $10.
To calculate your profit, subtract the premium you paid from the intrinsic value.
Formula:
Profit = (Market Price – Strike Price) – Premium
Example:
Suppose you paid a premium of $2 per share, and the intrinsic value is $10. Your profit would be:
Profit = $10 – $2 = $8 per share
Since one options contract typically covers 100 shares, you’ll need to multiply the profit per share by 100 to find the total profit.
Example:
If you bought one call option with a profit of $8 per share, your total profit would be:
Total Profit = $8 * 100 = $800
If the market price is below the strike price at expiration, the call option expires worthless, and your loss is the premium you paid for the option.
If the market price is $45 and the strike price is $50, the option has no intrinsic value. You lose the entire premium you paid, which might be $2 per share or $200 for one contract.
By following these steps, you can accurately calculate your call option profit and assess the potential return on your investment.
Call options generally work as an investment strategy, and they have the following key uses:
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.
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 asset’s cost, without purchasing the asset directly. If the asset’s price rises above strike price, investors may gain substantially at a relatively lower initial price.
Call options may also be used as a hedging tool to protect against the risk of missing out on potential gains. For example, if an investor is holding cash but anticipates a rise in a particular stock’s price, they may buy a call option as a way to hedge against the possibility of the stock rising. This may allow them to lock in the right to buy at a specific price in the future, without committing to purchasing the stock immediately.
You can control more shares with less upfront capital by using call options. This may let you amplify your potential gains with a smaller investment.
You can use call options to limit losses on other investments. If you have a short position, buying a call option may help you protect against unexpected price increases.
By incorporating call options into your investment portfolio, you may gain the flexibility to manage risk, generate income, or take advantage of market opportunities.
Investors may generally buy call options when they are optimistic about the financial market. Here are the primary scenarios where investors generally consider buying:
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:
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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.
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.
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.
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.
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.
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.
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.
