What is a Call Option?

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Definition:

A call option is a contract that gives the owner the right to buy a specific amount of stock or another asset at a specific price by a specific date.

🤔 Understanding a call option

A call option is one type of options contract. It gives the owner the right, but not the obligation, to buy a specific amount of stock (typically 100 shares) at a specific price (called the strike price) by a specific date (the expiration date). Simply stated, you can choose to “exercise” your rights under the contract, but you don’t have to. To obtain this right, you have to pay a price to own the call option — this is known as the option’s “premium.”

Generally speaking, if you buy a call option, you might expect the underlying stock’s price to rise. But unlike buying shares of stock, to potentially profit from the purchase of your call option, your strategy needs to be more precise. In fact, you have to predict a few things: the direction the stock will move, how far it will go up, and by what date in the future it will get there. Let’s look at an example.

Example

Imagine that stock in the fictional company Xavier’s Xylophones is trading for $50 per share on May 1st. Based on your research, you think Xavier’s Xylophones stock is going to increase by 20% sometime in the next four months. On that basis you buy the $55 call option that expires in August. The cost, or premium, of this option is $2. But, because the contract controls 100 shares of Xavier’s Xylophones, you must multiply the $2 by 100, meaning that you pay a total of $200 for each call option contract you purchase.

Fast forward to August: You were spot on with your prediction. Xavier’s Xylophones stock is now trading at $60 per share. As a result, the option you bought for $2 is now worth $5 (that is, the current price, $60, minus $55, your contract’s strike price). At this point you can do one of two things:

  1. Assuming you have the money in your account and you want to take on the risk of owning the stock, you may exercise your right to buy 100 shares of Xavier’s Xylophones stock at $55.
  2. Sell your contract in the open market for a potential profit of $300 ($5 gain - $2 premium = $3 x 100 shares per contract = $300).

If you choose #1, you would be buying the stock for $5 dollars per/share less than the current market value of $60. Does that mean you have an instant profit of $500? Not quite. Remember, you paid $200 for the right to buy the stock at $55. So, technically if you sold your shares at $60, you would only have a profit of $300 when you account for the cost of your call option.

Generally speaking, most options traders choose #2; selling their call option for the fair market value of $5, keeping the $300 profit, and forgoing their right to buy the stock at $55.

Alternate Universe: You were wrong. At the option’s expiration, Xavier’s Xylophones trades for $40 per share. In this instance the call option expires worthless and you lose your $200. Why? Simply put, it wouldn’t make sense to buy shares of Xavier’s Xylophones for $55 dollars, when you could buy them in the open market for $40.

On the bright side, if you bought 100 shares of Xavier’s Xylophones stock at $50 per share in May, you’d be down $1,000 on your investment. But, because you chose to buy a call option, your risk was limited to what you paid, which was $200. Meanwhile, in our first scenario, if the stock went to $60, you could have made more money owning the stock ($1,000 vs. $300), but your initial investment would have been $5,500 instead of $200.

Takeaway

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.

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How does a call option work?

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.

How is a call option different from a put option?

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.

What strategies are used in trading call options?

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.

What are the potential risks and rewards of call options?

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.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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