How Do Option Calls Work?
A n option is a type of financial contract called a derivative. A derivative varies in price based on the price changes of an underlying stock, security, or asset. Unlike stocks, options do not represent a portion of equity in a company. However, because you can get out of your options position at any time, they carry less risk than less liquid assets like stocks and bonds.
Short-term options expire within months, while long-term options last longer than a year and are often called LEAPS (Long-Term Equity Anticipation Securities). Like other investments, options are available for purchase through your trading account with a brokerage firm. Learning how options work gives you a powerful tool that can potentially increase profits and shield your portfolio against risk.
- Derivative assets such as options vary in price based on the price changes of another financial instrument such as a stock, known as the underlying asset.
- Options create the potential for profit with limited risk compared to the risk associated with stocks, bonds, and other less-liquid securities.
- With a call option, you have the right to buy the underlying asset at a set price, called the strike price, even if its market value rises above that price.
- You pay a premium price per share for a call option, and most options consist of 100 shares.
- The counterpart to a call option is a put option, which gives you the right to sell shares of a stock at a certain price even if its market price drops.
- Some of the benefits of option calls include risk management, the ability to create profit and income, and limited risk.
- The further an asset is ‘in the money,’ the more likely it is to be profitable by its expiration date.
- Some of the common strategies using call options include covered calls, stock speculation, call spreads, and tax management.
What Are Option Calls?
How do option calls work? When you buy a call option, you are buying the right to purchase a financial instrument such as a commodity, bond, or stock at some point in the future. The option establishes a set price for the purchase, called the strike price, and an expiration date by which you must exercise the option to buy the shares. If you decide not to do so, the option expires. You would use a call option if you expect the underlying share price to rise before the expiration date. You can exercise an American-style option anytime before its expiration date, while a European-style option can be exercised only on the expiration date.
The cost of an option is called its premium price, and it’s quoted by share. Usually, an option consists of 100 shares, so the total premium for a $2 option would be $200. If you let your call option expire without exercising the right to buy those shares, you lose only the premium you paid. The person who sells you the option is in the so-called short position, while you hold the long position.
To understand more about how call options work, let’s look at an example of an option call. Pretend you buy a $200 stock option for 100 shares as described above. The strike price of your option is $80, and shares of the stock are trading at $90 on the expiration date. If you exercise your call option, you can buy the shares at $80 and make an instant profit of $10 per share ($1,000 total) if you turn around and sell them for $90 on the open market. On the other hand, if the share price drops below the strike price you can let your option expire and lose only the $100 premium.
An option call that gives you the right to sell a certain number of shares at a certain price is called a put option. You place a put option if you expect the underlying asset to drop in value. If this occurs, you can sell your shares at the higher strike price.
Benefits of Option Calls
Traders appreciate option calls because they provide the opportunity to profit regardless of current market conditions (bear, bull, or flat). If your portfolio is stacked with steady, high-performing blue-chip stocks, you can sell options on your holdings to generate an additional income stream from the premiums. In the right circumstances, some call options create a return of up to 300% on your investment in a single day. That means if you spend $200 on a call option, you could earn as much as $600 in profit.
Traders say that a call option is ‘in the money’ if it is profitable. This occurs when the price of the underlying asset exceeds the strike price of the call. When the underlying asset price meets the strike price, the asset is considered at-the-money. When the strike price is higher than the price of the underlying asset, the asset is out-of-the-money. An option has no value if it is at-the-money or out-of-the-money at expiration.
Strategies Using Option Calls
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The long call option strategy is the most basic way to get started with options. You simply buy a call option on an asset you think will rise over time. If it does, you buy it at the low strike price and resell it at the higher market value. If it drops, you let the option expire and lose only your premium price.
You’re probably curious about how option calls work when you combine them with other strategies. One such strategy is a covered call, designed to create a stream of income using call options. With a covered call, you sell a call option to another investor for an underlying asset you already own. You collect the premium price for the asset as a profit and hope that the option expires without value. If the price of the asset exceeds the call price, however, the person who bought the option can exercise it and buy your shares at the lower strike price.
Some traders use options contracts to speculate on a stock without a large initial investment. As long as you can afford the premium price, you can potentially realize significant gains on the price rise of a stock you couldn’t otherwise manage to purchase. With this strategy, called speculation, you limit your risk only to the amount you pay for the option premium.
You can also use a call spread, in which you sell and buy different call options at the same time. While this strategy limits your loss, it also caps your potential profit. However, it can also protect your premium by hedging the various options against one another.
With a bull call spread, you buy an option call for with a certain expiration date and strike price, then sell an option call for the same number of shares with the same expiration date and a higher strike price. Selling the calls offsets the cost of this transaction, but you limit your profit to the strike price on the second call.
For potentially exponential profits with limited initial cost, go for the long call butterfly strategy. For this technique, set a target price for the stock and then sell two call options that have your target as the strike price. Sell a third call option at a strike price above your target, then buy a call option at a strike price below your target. If the underlying asset hits the target price, you can let all the sold options expire while generating profits from the call option you purchased.
Tax management is another possible advantage of using an option call. For example, a trader can update portfolio allocations by adding options instead of buying or selling the actual holdings. This reduces the investor’s risk exposure to a declining security without incurring the tax associated with selling it outright.
Now that you know the answer to the question of how do call and put options work, you’re one step closer to implementing these tactics in your own trading strategy.