Explanation of Call Options

Characteristics

A call option is a financial contract between two parties: the holder and the writer. The holder of the call is the owner of the contract; this means they have purchased the right to buy the underlying security. The seller of the call is called the writer, and they sell the contract for a price which is paid by the holder. The contract would contain terms for the strike price, the underlying security, and the expiration date.

The underlying security is the asset on which the contract is based. For example, if you bought a call based on shares in Company X, then you would be buying the right to purchase shares in that company. The strike price stipulates the price at which you have the option of purchasing the underlying security. The expiration date is, quite simply, the date on which the contract expires.

With an American style option, the holder can choose to buy the underlying asset at any time before the expiration date. This is more flexible than a European style option where the holder cannot buy the underlying security until the expiration date; they must make a decision at that point whether to do so or whether to let the contract expire.

Should the holder of a call go ahead and initiate the purchase of the underlying security, this is known as exercising their option. The holder can also, at any time, choose to try and sell their contracts.

There are three distinct states that the holder of a call contracts can experience – in the money, at the money, or out of the money. In the money is when the underlying security is at a higher price than the strike price, at the money is when the security is equal to the strike price and out of the money is when the security is worth less than the strike price. The obvious time for the holder of a call to exercise their option, or sell it, is when it is in the money, but there are a a number of factors that may influence their decision.

Price

The price of calls is mostly determined by how the strike price compares to the current price of the underlying asset. For example, if you were buying a call and the contract gave you the option of buying company stock at a strike price that was lower than the current trading price of that stock (i.e. it was in the money) then you would essentially be buying theoretical profit that was already in the contract. This profit is known as intrinsic value and is one of two components that make up the price of call options; the other one is extrinsic value.

The extrinsic value is the part of the price that you pay to the seller or writer of the contract for the right to own the contract. This basically serves as compensation to the writer of the contract for the risk that they are exposing themselves to. The price of a call that is at the money or out of the money (i.e. with no built in profit) would be made up entirely of extrinsic value. The following simplified example illustrates how the pricing works.

Shares in Company X are trading at $100 and the following call contracts are available for sale at the specified ask price.

• $103 Strike Price - $2.00 Ask Price
• $100 Strike Price - $4.00 Ask Price
• $98 Strike Price - $6.00 Ask Price

The first contract is out of the money because the strike price is higher than the current trading price. The $2.00 price is made up entirely of extrinsic value, as there is no existing profit. You would need the stock to rise above $103 before you could exercise your option and make a profit.

The second contract is at the money options– as the strike price is equal to the current trading price. The $4.00 price is also made up entirely of extrinsic value due to there being no existing profit. The extrinsic value is higher than the above example, as the stock does not need to rise in price as much before you could exercise and make a profit.

The third contract is in the money options shows that the strike price is above the current trading price. The $6.00 price is made of $2.00 intrinsic value to represent the $2.00 profit that is already in the contract. The remaining $4.00 is the extrinsic value.

Benefits of Trading Calls

Trading calls is a great way to take advantage of the price movements of various assets without having to actually own those assets. They are good leverage tools that can potentially provide big profits relative to the amount risked. With calls it's possible to benefit from the rising prices of the relevant underlying security without the same level of risk exposure of owning that security.

For example, if you buy a call based on the stock of a particular company and that stock falls dramatically in price then you don’t necessarily suffer that entire loss of value. Your losses would be limited to the amount you had paid for the options contract. If the stock does go up in price then you can either exercise your option to buy the stock or sell the contract to realize your profit.

Calls are also a useful instrument for hedging against price changes in investments that you already own. You may also like to read the section on Strategies for Trading Options for more details of some trading strategies that involve the use of calls.

The examples below highlight how calls can be used as an alternative to actually investing in stocks. These examples are somewhat simplified but they at least give you an idea of some of the advantages. For the sake of these examples we are ignoring commissions and fees incurred for buying and selling stocks and options contracts.

Example 1

Stock in Company X is trading at $100 and you have $10,000 capital to invest. You believe that the stock is going to rise in price so you choose to invest your $10,000 capital in 100 shares of this company. The stock does indeed rise to $105 and you choose to sell your 100 shares for a profit of $500.

Example 2

Rather than buying shares in Company X, you decide to buy calls. Calls with a strike price of $100 are trading at $4.00, and you invest just $4,000 of your capital in options contracts. This would give you the right to purchase 1,000 shares in the company at the strike price of $100. With the stock rising to $105, you could exercise your option to buy 1,000 shares at $100 and sell immediately at $105 for a gross profit of $5,000.

After taking the original investment of $4,000 into account, you have made a total of $1,000. By buying calls instead of stocks, you made double the profit and only risked a portion of your capital.

It's worth pointing out, however, that there are some disadvantages to owning calls too. There is always the risk of an options contract expiring with no value if the stock trades below the strike price until the expiration date. Also, if you are investing in stock options rather than stocks themselves then you don't receive a dividend if one is paid out to stockholders.

Buying & Selling Calls

To trade calls you will need to engage the services of a suitable broker who can execute your transactions for you on the exchanges. The simplest and easiest way to buy and sell them is by opening an account with an online stockbroker. If you would like further information on choosing an online broker and some recommendations of the best ones, please visit our section on Best Options Brokers.