Call options are a type of option whose value grows as a stock’s price rises. They are the most common option and allow the owner to lock in a price to purchase a particular stock by a certain date. The attractiveness of call options is that they might appreciate rapidly on a minor increase in the stock price. Consequently, this makes them a favorite among traders seeking substantial profits. Thus, in this article, we will deeply learn more about it together.
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What Exactly Is a Call Option?
When you purchase a call option, you are provided with the right. However, buying a stock at a predetermined price is not an obligation. This price is referred to as the striking price by a predetermined date, which is the option’s expiration date. Significantly, the call buyer will pay a sum referred to as a premium in exchange for this right. The call seller will be the recipient of this premium. In contrast to stocks, which can exist for an infinite amount of time, an option will cease to exist after its expiration date. It will either be worthless or have some value.
Each contract represents 100 shares of the underlying stock and is referred to as an option. Exchanges quote option prices in terms of the price per share, not the overall cost to acquire the contract. On the exchange, an option may be quoted for $0.75. One contract will cost (100 shares * 1 contract * $0.75), or $75.
The following characteristics comprise the key features of an option.
- Strike price
It is the price at which the underlying shares can be purchased.
- Premium
It is the cost of an option for a buyer or seller.
- Expiration
This is the time after the option has expired and been settled.
The Working Principles of Call Option
When the stock price at expiration is higher than the strike price, call options are considered “in the money.” The owner of the call option can exercise this option by exercising their right to buy the shares at the strike price. In addition, the owner might simply sell the option to another bidder before it expires at a price determined by the option’s fair market value.
When the difference between the stock’s current price and the strike price is smaller than the premium, the call option owner makes a profit. An example is a situation where a trader paid $0.50 for a call option with a strike price of $20, and the stock ended up being $23 when the option expired. The option has a value of $3 (the $23 stock price less the $20 strike price), and the trader has achieved a profit of $2.50 (the $3 value of the option minus the $0.50 cost of the trade).
If the current stock price is lower than the strike price when the option contract expires, the call will be considered “out of the money” and worthless. The call seller keeps the option premium that is collected.
The Importance of Buying a Call Option
The most significant benefit of purchasing a call option is that it magnifies price appreciation. You can enjoy a stock’s gains above the strike price until the option expires for a relatively low upfront investment. Therefore, if you purchase a call option, you often anticipate that the stock price will climb before expiration.
Imagine that the share price of stock XYZ is $20. You can purchase a call option with a strike price of $20 and an expiration date of eight months for $2. One contract costs $200, or $2 * 100 shares * 1 contract.
Here is the profit at expiration for the trader.
As can be seen, the value of the option, upon expiration, increases by $100 for every dollar gain in the stock price above the strike price as the stock climbs from $23 to $24, a 4.3 percent increase, the trader’s profit increases from $100 to $200, a 100 percent increase.
Even if the option expires in the money, the trader may not have made a profit. In this example, the premium per contract was $2. Therefore, the option is profitable at $22 per share, which is the strike price of $20 plus the premium. Only at that threshold does the call buyer generate a profit.
The call option will retain some value if the stock closes between $20 and $22. However, the trader will ultimately incur a loss. Moreover, below $20 per share, the option expires worthless, and the buyer of the call forfeits the entire investment.
The attraction of buying calls is that they significantly magnify a trader’s gains relative to stock ownership. A trader might buy ten shares of stock or one call with the same starting cost of $200.
The Importance of Selling a Call Option
For every call purchased, another call is sold. In short, the payout structure for purchasing a call is the opposite. Call sellers anticipate that the underlying stock will remain unchanged or drop, and they intend to pocket the premium risk-free.
Let’s utilize the same illustration as before. Imagine that the share price of stock XYZ is $20. You can sell a call option with a strike price of $20 and an expiration date of eight months for $2. One contract offers you $200 ($2 * 1 contract * 100 shares).
Here is the profit at expiration for the trader.
In this instance, the payout schedule is the exact reverse of that of the call buyer.
- The option expires worthless for each point below the $20 strike price, and the call seller retains the cash premium.
- Between $20 and $22, the call seller earns a portion of the premium, but not all.
- Over $22 per share, the call seller loses money over the $200 premium received.
The attraction of selling calls is that you earn an upfront cash premium. Moreover, you are not required to make an outlay immediately. Then, you must wait until the stock’s expiration date. You will gain money if the stock falls, stays flat, or even climbs. You also will not be able to double your funds in the same manner as a call buyer. As a call seller, you will only earn the premium.
While selling a call may appear to be a low-risk strategy, it can be one of the most dangerous options strategies due to the possibility of unlimited losses if the underlying stock climbs.
For instance, if the stock doubled to $40 a share, the call seller would incur a net loss of $1,800, which is the difference between the option’s $2,000 value and the $200 premium received. However, several safe call-selling tactics, such as the covered call, could be employed to safeguard the seller.
Call Options vs. Put Options
Genuinely, put options are the second major type of option. Its value rises as the stock price falls. Therefore, traders can bet on stock depreciation by purchasing put options. In this way, put options function similarly to the opposite of call options, although having many similar risks and rewards.
- Similar to purchasing a call option, purchasing a put option allows you to earn back several times your initial investment.
- Similar to purchasing a call option, purchasing a put option carries the risk of losing the entire investment if the put expires worthless.
- Like a call option, selling a put option results in a premium. However, the seller assumes the entire risk if the underlying security moves in an adverse direction.
- Unlike selling a call option, selling a put option exposes you to limited losses. Nevertheless, you could lose several times the amount of the premium.
Conclusion
Options can be risky, but there are sensible ways for traders to employ them. In reality, if used properly, options can reduce risk while still allowing you to profit from a stock’s gain or loss. Certainly, if you still wish to attempt a home run, options give you the chance to do so.
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Read more: Stocks
Source: Bankrate