The definition of a call option is a contract that is sold by one party to another that gives the buyer the right, but not the obligation, to purchase an underlying stock at a specified price, known as the strike price, by an agreed-upon expiration date.
A call option, which represents 100 shares of the underlying stock, are a type of security, just like stocks, bonds, or other financial assets, that an investor may use to diversify his portfolio and maximize his overall profits. There are two types of options: a call option and a put option, but this article specifically will focus on how to buy and sell call options, as well as the risk involved in such trades.
The difference between buying and selling a call option is that an investor will buy a call option when he thinks the value of the underlying stock will increase. An investor will sell a call option when he thinks the value of the underlying stock will decrease or stay the same. The buyer of a call option is known as the option holder. The seller of a call option is known as the option writer.
The option holder pays the option writer a premium for the option. If the option holder exercises his right on the call option and buys shares of the underlying stock at the strike price by the expiration date, then the writer is obligated to sell him those shares at the strike price. If the option holder doesn’t exercise his right, then the option will expire and become worthless.
The option holder can exercise his right on the option when the option is “in-the-money.” This means that the market value of the stock is above the strike price before the expiration date. Alternatively, the option holder can’t exercise his right when the market value of the stock is below the strike price before the expiration date. This is known to be “out-the-money.”
The option holder will profit when the underlying stock value increases above the strike price by an amount greater than the premium paid. The option writer will profit when the option expires and becomes worthless, while keeping the premium paid to him by the option holder.
The call option holder’s biggest risk is the premium he paid for the call option. The premium price depends on the strike price, stock price, expiration date and volatility of the stock. In general, the higher the strike price is relative to the market price of the underlying security, then the lower the premium. The call option writer’s biggest risk is losing the amount gained from the premium by the amount the stock price rises above the strike price, which could be unlimited.
Here are a couple examples and strategies that can tie these concepts relating to call options together.
- Call Option Holder: Assume Company “XYZ” has a price per share of $30. An investor buys one call option for XYZ with a strike price of $35 that expires in one month. The buyer expects the stock price to rise above $35 in the next month. Now the buyer has the right to purchase 100 shares of XYZ at a price of $35 until the expiration date. The buyer pays a premium for the call option of $2 per share, or $200 in total, to the option writer. Assume the share price of XYZ rises to $40 in that month. Now the buyer can exercise the call option and buy 100 shares of stock at $35, rather than $40, for a total of $3,500. He then can sell the shares at the market price of $40. This generates a profit for the buyer of $4,000 – $3,500 – $200 = $300. If the share price never rises above the strike price, then the call option expires, and the buyer loses the $200 he paid for the premium.
- Call Option Writer: Assume Company “XYZ” has a price per share of $10. An option seller expects the market value of XYZ to decrease or stay the same. So, the option seller writes one call option for a premium of $1 per share, or a total of $100. That is the amount the seller receives. The option has a strike price of $12 and expires in three weeks. Assume that in those three weeks, XYZ never rises to $12 and the option expires as worthless. The option writer keeps a profit of $100 from the premium paid to him by the option buyer.