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An Explanation of Call Options

There are two types of options you can trade: call options and put options. Many people have misconceptions that options trading could lead to worthless stocks and a loss of your investment. However, when you know the right options trading strategies, you can use call and put options as a way to enhance your portfolio. Learn more about what exactly call options are and how to use them to your benefit.

What Is a Call Option?

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A call option is a contract that gives you the right to buy a stock at a set price on or before a predetermined date, but with no obligation to do so. This set price is called your strike price. A call option increases in value when the price of a stock rises. That’s because you can purchase it at a low strike price and profit when the price rises over time.

Important Call Option Terms

In order to truly understand what a call option is, you need to know these important terms:

  • Strike price: The price you can purchase the underlying asset for. This price remains the same throughout the life of the option contract.
  • Premium: The price a buyer or seller must pay to have the rights of an option.
  • Expiration date: The last day you can exercise your rights. After this day, the option ceases to exist.
  • In the money: When the underlying asset price is below the put strike price.
  • Out of the money: When the underlying asset price is more than the put strike price.
  • At the money: When both the underlying asset price and put strike price are the same.

How Do Call Options Work?

In order to have the right to buy a stock, you must pay a premium. The seller of this option will receive this amount of money. Although regular stocks can live on, both call and put options no longer exist after their expiration date. By the end of the option’s life, it’ll either hold some value or be worthless.

Options typically have a weekly, monthly, or quarterly expiration date. The length of an option can help you determine your risk and what you are willing to invest in.

How to Calculate the Price of a Call Option

Each option represents 100 shares of the underlying stock you wish to purchase. When buying an option, the exchange you shop from lists the price of each share, rather than the total price of the contract. Calculate this total price by multiplying the price of an underlying stock by 100. For instance, if a stock is $10 a share, then the option contract would cost $1,000.

The Benefits of Buying a Call Option

Buying a call option can be a savvy decision when a stock gains above the strike price over the course of the contract’s term. The main benefit is that it amplifies a stock price’s gains. You would buy a call option when you anticipate a stock to rise before the set expiration date.

The Benefits of Selling a Call Option

Along with buying a call, you can also sell a call option. The key reason investors do this is to get their premium without losing any money. You would sell your call when you expect the market to remain flat or decline. One drawback is that you would only make your premium and have no chance of capitalizing on a growing stock. When buying a call option, you can make a nice profit when you hit the market right.

Call vs. Put Options

Now that you know what a call option is, just know that a put option is the opposite. Rather than having the right to buy, you have the right to sell at a strike price by a predetermined date. Investors choose put options when they think the market will decline. This can be explained by the fact that put options usually increase in value when the price of the underlying asset falls.

Why Investors Use Options

Like any other investment, options are speculative in nature and come with a risk. When you use them correctly, you can enhance your portfolio. More seasoned investors use options for the following reasons:

Generating Income

It’s possible to make some income with the covered call strategy, when you simultaneously own an underlying stock while writing a call option or allowing someone to purchase your stock. The idea is that you receive the premium from the buyer, and the option is worthless by the time it expires. It would be worthless if it is below the strike price by this time. Be aware that you may limit your profit if the price of the underlying stock were to suddenly rise.

Speculative Gains

If you hit the market right, you can make a decent profit off of options. Your brief exposure to a stock for a low price can let you capitalize on your predictions of the stock market declining or rising. One downside is that you could lose your entire premium if the call option loses all of its value by the end of its life. Buying call options is one way investors lower their risk, since it maxes out at the premium they spent on the option.

Another strategy investors use to lower their risk is called creating a call spread. This is when you buy and sell different call options at the same time to balance the profit and loss of each option.

Tax Management

You can use options to change your portfolio without having to buy or sell any of your securities. For example, let’s say you own 300 shares of stock in a company that might experience large unrealized capital gains. If you want to avoid a taxable event, you can use options to lower the security’s exposure without selling it. Keep in mind that gains from your options are taxable but often more complex. Often, shareholders will experience lower costs.

How Do You Trade Call Options?

Is all this talk about call options making you feel eager to get started? First, you need to find a brokerage firm that can make trades on your behalf. Finding a brokerage firm that offers support and guidance can help you make smarter trades.

If you prefer to work on a party-to-party basis, look into trading through the over-the-counter (OTC) market. OTC stocks are considered unlisted and come from small businesses most of the time. That’s because the OTC markets have fewer restrictions than the national exchanges, like the New York Stock Exchange and NASDAQ.

Key Takeaways

  • A call option is a contract that gives you the right to buy a stock at a predetermined price on or before a set date.
  • Investors choose call options when they expect the market to rise.
  • You can calculate the price of a call option by multiplying the price of an underlying stock by 100.
  • Buying a call option allows you to maximize your capital gains on a rising stock, while selling a call option lets you get your premium without losing money.
  • Put options are the opposite of call options, as they give you the right to sell a stock at a predetermined price on or before a set date.

Trading options is a bit complicated at first, but by knowing the difference between call and put options, you’re already ahead of the game.