What is a Call Option?

Call options, in some ways, are like a grocery store coupon...

They give you the right to buy a specific quantity of an exact item, for a certain price, before the coupon expires. However, if you find the same item at another grocery store for cheaper, you probably won’t use the coupon.

When you buy a call option, you’re buying the right, but not the obligation, to purchase a certain amount of a stock (or another asset) for a certain price by a certain time. The person who sells you the call option is obligated to sell you stock at that price, if you choose to exercise your rights under the contract.

The amount you pay for an option — typically a fraction of the stock price — is called the premium. It is the cost of the option and is based on a number of different factors including: the current price of the underlying stock in relation the strike price of the option, the time left until the option expires, and something called “implied volatility.”

Implied volatility essentially measures the supply and demand for the option. Think of it like when you pay a surge price for an Uber. You’re not paying for a longer ride, or a better car, you’re simply paying more because at that moment, there are more people seeking rides than there are drivers available. Hence, the extra cost. Just like prices on Ubers, implied volatility on options is always rising and falling based on supply and demand.

There are other factors that affect the price of options including interest rates and whether or not the underlying stock pays a dividend. But typically these have less of an impact on an option’s price, especially when there is less time until expiration.

When you buy a call option, you’re betting that the stock price will rise above the strike price before the option expires. If it rises enough to cover the premium you paid, then the trade might be profitable. You also have the potential to profit if implied volatility rises. In this case, even though the stock price hasn’t necessarily moved, the demand for your call option could result in the price increasing.

If the stock rises above the strike price, the call option you bought is said to be in the money (ITM) — You have the right to buy the stock at the strike price even though it’s worth more in the open market.

If the stock is below the strike price, the option is out of the money (OTM). You can still buy the stock, but it’d be pointless to do so, since you could buy it for less than that in the open market. If the stock doesn’t rise above the strike price by the time the option expires, and the option becomes worthless.

A put option is the flip side of a call option. Just as a call option gives you the right to buy a stock at a certain price during a certain time period, a put option gives you the right to sell a stock at a certain price during a certain time period. Think of it as “putting” the stock to the person on the other end of the transaction — You’re forcing that person to buy the stock from you at the specified price.

So turn everything around. If you’re buying a put option, you’re betting the stock will fall below the strike price. In that scenario, the other investor is obligated to buy the shares at the strike price, which is higher than the market price — That’s where your potential profit comes from.

If you’re selling a put option, on the other hand, you understand you may have to purchase shares from the buyer at a price higher than the market, in the event the stock price falls. In this case, the premium translates into compensation for taking on that risk.

Call options can be used in a number of ways. They can be used to speculate on the price of a stock or to help generate income, by selling options against shares you own. They can also be used to hedge: You can buy an option that represents a bet opposite to one you’ve placed elsewhere — If you’re shorting a stock, you can buy call options, in order to hedge your potential losses from the stock rising.

When you purchase a call option, the most you can lose on the call option is what you pay for it. If the stock does not exceed the strike price by expiration, the option will expire with no value, or worthless. At that point, the stock could go to $0 and you would still only lose what you paid for the call option. The tradeoff is that if the stock goes up, you won’t make as much money as if you simply bought 100 shares of the stock.

However, if your rights are exercised, and you purchase 100 shares of the underlying stock, your potential risk immediately changes. Imagine in our previous example above, your call option was exercised and you bought 100 shares of XYZ at $55. Your risk is now $5,500, plus the amount you paid for the option, which was $200. So, if XYZ goes out of business and the stock goes to $0, you will have potentially lost $5,700 on the entire investment.

Also, be aware of your broker’s automatic exercise policies. Most brokers will automatically exercise your call option if the stock is trading 1 penny or more higher than the strike price. You might think your option is going to expire worthless on expiration day, but stocks can make large, last minute swings, turning a worthless option into one that is exercised automatically, resulting in stock risk. It is important to keep an eye on your position going into expiration, and proactively manage it accordingly.

What is the potential reward of buying a call option? Technically, it is infinite. If you buy a call option, the stock could theoretically go up forever. As a result, your call option will continually increase in value until you either sell it, or exercise your rights to buy the stock. However, since options have a defined lifespan, and depending on which call option you buy, certain factors put the odds against you. Generally speaking, whenever you buy a call option, the probability of being successful is less than a 50/50 chance.

Sellers of call options that own the underlying stock, on the other hand, know that they could lose their shares to the buyer if the stock price rallies past the strike price, and so the premium they collect for selling the option is essentially compensation for selling the buyer the right to buy the stock.

Some sellers of call options do not own the stock, and in that instance are taking on infinite risk because the stock can go up forever. If their short call is assigned, they will take on a short stock position. This is referred to as being “naked short calls.” It is something only allowed in certain brokerage accounts, and requires higher levels of trading approvals by your brokerage firm.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.

Examples are hypothetical, and do not reflect actual or anticipated results, and are not guarantees of future results.