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What is a Call Option?

definition

A call option is a contract that gives an investor 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 a contract that gives an investor the right to buy a specific amount of stock or another asset at a specific price by a specific timeframe. It’s a way of betting aggressively that the value of the asset will rise or fall the way you think it will — and quickly. If you buy a call option, for instance, and the stock’s value moves above the option’s “strike price” before the option expires, you can exercise the option and make money. If it doesn’t, you lose your entire investment. Call options can also be used in a variety of ways beyond speculating on stock price increases, like stemming potential losses, and capitalizing on the merger and takeover activity in the market.

example

In October 2019, an options trader or traders bought Tesla call options in a bet that the company would report strong third-quarter earnings later that day. According to CNBC.com, the traders spent more than $4 million buying 6,000 Tesla November call option contracts with a strike price of $280, at a time when Tesla stock was trading in the 250s. The bet paid off: After Tesla reported favorable earnings, the stock jumped to the 290s the next day, above the strike price. A market observer suggested the traders may also have sold Tesla options with a strike price of $230, locking in some profits at the same time the November 280 options were purchased. (Source: CNBC.com, 10/23/19. Past performance is not indicative of future results.)

Takeaway

Buying a call option is like getting a chance to buy the car you want at a good price — But only if you act quickly...

You decide on the make of the car, the color, the options. The dealer has that exact car, on sale — But for a limited time. Think of call options the same way — Each trade has its own features (contract terms) and agreed cost (strike price). You have the option to buy the car or the stock at the quoted price before it expires.

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How does a call option work?
How is a call option different from a put option?
What strategies are used in trading call options?
What are the potential risks and rewards of call options?

How does a call option work?

When you buy a call option, you’re buying the right to purchase a certain amount of a stock (or other asset) for a certain price by a certain time. So, to take a hypothetical example, you might buy a November 250 call option on Apple — The right to buy 100 shares of Apple for $250 a share before the option expires in November.

Think of it like shaking hands on a deal. If you buy a call option, you are locking in a future purchase price for a stock. The person who sells you the call option, on the other hand, is agreeing to sell you their stock at that price. They’re looking for income — They’re charging you an amount to get that option.

That amount — typically a fraction of the stock price — is called the premium, and it measures how much value the option has, based on where the underlying stock is currently trading, how close that is to the future price you’ve agreed upon, and how much time you have to exercise the option. The amount for which you can buy the stock, $250, is called the strike price.

When you buy a call option, you’re betting that the stock price will rise above the strike price before the option expires. That’s what makes the trade profitable. In this example, if Apple stock rises above $250, the call option you bought is said to be in the money — You have the right to buy the stock for $250 even though it’s worth more, and so you can buy those shares at the lower price, turn around and sell them, and make a profit. When a call option is in the money, the option itself is more valuable, and so you could simply sell the option and make a profit, too.

If the stock is below $250, the option is out of the money. You can still buy the stock for $250, 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 $250 by the time the option expires, the option is worthless.

Sellers of call options, 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 is essentially compensation for selling the buyer the right to buy the stock.

How is a call option different from a put option?

A call option is the flip side of a put 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 price on 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. That way, you can force the other investor to buy the shares at the strike price, which is higher than the market price — That’s where your profit comes from.

Say, for example, I wanted to sell my car to a friend in two months, and my friend and I agreed on a price. I would buy a put option off my friend, which would mean that whatever happens, I could sell the car to him at the agreed price — Even if it declined in value sharply during that time.

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 collapses. In this case, the premium translates into compensation for taking on that risk.

What strategies are used in trading call options?

Call options are a jack of all trades. They can be used straightforwardly, to speculate on price rises and falls. They can be used to help generate income, by selling options on shares you own to another investor who wants to bet on the direction of a stock. They can 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 that represent a bet it’ll go up, in order to hedge your potential losses from the short bet.

Or you can use “spreading.” Let’s say an investor is bullish on the market - or bearish - but wants to limit their potential loss and reduce their upfront cost. So the investor buys one call option and sells another on the same stock but at a different strike price. That caps the possible gains, but also limits the losses, and reduces the cost or brings in income.

What are the potential risks and rewards of call options?

Looking at it one way, buying call options can be very risky: If they’re out of the money when they expire, you lose the entire amount you’ve paid. But looking at it another way, they’re a way to speculate while limiting risk: If you buy or short-sell the shares, you’re on the hook for the entire amount of any big change in their price in the direction opposite from your bet — The price could fall all the way to zero, or a short bet could be ruined if the company has good news and its price suddenly soars. But if you use options, you’re risking only the premium you’ve paid, while still benefiting from most of the potential upside you’d get if the shares go into the money. (That’s part of the reason why professional investors like hedge funds use them to bet on potential mergers and acquisitions — It’s a relatively low-cost way for them to do so.)

To take a fictitious example, let’s say Karen, a retired school teacher, has become increasingly concerned about the meteoric rise in the stock market and whether it will continue to have legs. But she’s interested in a tech stock and wants to add it to her portfolio. Instead of buying the shares, she decides to purchase a call. If the stock rises, she can use the option to buy the shares at a bargain price and reap most of the same upside she’d get from buying the stock in the first place. But if the market tanks, her only loss is the premium she paid for the option — Not the tumble in the stock itself.

Options can also be used for income. Another fictitious example: Johnny has a sizeable portfolio, but most of his stocks are not dividend-paying, so they don’t generate income. Johnny writes/sells a call option against one of his stocks and receives a premium in return. And if the stock price doesn’t rise past the strike price, he doesn’t have to sell his shares.

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.

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