What is a call option?

In a nutshell

An option is a type of financial instrument based on the value of an underlying asset: Stocks, indexes, and exchange-traded funds (ETFs), among others.

• An options contract gives the holder of the contract the right to buy or sell the underlying asset at a stated price within a specified period of time. It is important to note that the holder of the contract has the right, but not the obligation, to buy or sell the asset.
• The buyer pays a premium — a fee — to purchase the option.
• A call option allows the holder of the contract to buy the asset at a stated price within a specific timeframe.
• If the buyer of the call option decides to exercise their right to call the option, the seller must sell the underlying asset at the agreed-upon price.

In the scenario described above, the call buyer will earn a profit because the price of the underlying asset increases. However, the value of the underlying asset may not increase. If the call buyer doesn’t exercise the option (because the value of the underlying asset has decreased or for any other reason), the seller earns a profit because they get to keep the premium the buyer paid.

How does a call option work?

Suppose the underlying asset for a call option is stock in company XYZ. The call option contract gives the buyer the right to purchase XYZ stock at a certain price by a specific date. The specified price is called the strike price. The date is referred to as the expiration date. The buyer of the call option pays a fee per share, called the premium.

The call option buyer will exercise the option only if the stock’s valuation rises above the strike price. For example, if the strike price is $100, the buyer will exercise the option if the price of the stock reaches $101 or higher. For example, if the option contract is for 100 shares, and the price of the stock is $110, the buyer will reap an immediate gain of $1,000 (100 shares x $10 difference between the share price and the strike price).

However, the cost of the premium must also be deducted from this immediate gain. If the buyer paid a $2 per share premium, their gain would be reduced by $200 (100 shares x $2).

If the buyer does not exercise the option, the seller will keep the $200 premium. If exercised, the seller will still get the $200 premium.

The benefit to the seller of a call option

It’s easy to see why someone might buy a call option, but why might an investor sell an option?

For the call seller, the incentive is the premium paid by the buyer. In the above example, the buyer paid a $100 premium for the option, and the premium is paid whether or not the option is exercised.

The seller is making a bet that the stock will not rise above the strike price. If the option is not exercised, they will receive $100 for participating in the call option transaction.

However, it should be noted: When a call buyer exercises the option — and buys the stock at the strike price even though the market price of the share is higher — the seller loses out on those gains.

For example, if a buyer exercises an option with a strike price of $50 and a market price of $55, the seller loses out on the price gain of $5 per share. The seller gets to keep the $100 call option premium but gives up $500 in the share price gain.

Call options pros and cons

Buying and selling call options

You’ll need to work with an investment broker that is able to support options trading, if you want to try options. Two popular examples of brokers that allow customers to trade options are Robinhood and E*TRADE. While both provide diversified investment opportunities, each is especially strong in options trading.

If you’re going to buy an option on a stock, there should be a reasonable expectation its price will rise before the option contract expires. If not, you will be out the cost of the option premium and any commissions charged by the broker.

Every option has three components:

• Strike price: the price at which the call option buyer will purchase the underlying asset.
• Expiration date: the date by which the option must be exercised, after which it expires and becomes worthless.
• Premium: a fee paid to the call option seller for entering the contract. This is a cost to the buyer and revenue to the seller. The premium is multiplied by the number of shares in the contract to arrive at the total premium cost.

Call options have three potential outcomes for the buyer:

• In the money: a call option where the strike price is below the price of the underlying asset at the time of expiration. (Results in a profit.)
• At the money: a call option where the strike price is equal to the price of the underlying asset at the time of expiration. (No immediate gain on the option, and you are out the premium paid.)
• Out of the money: a call option where the strike price is above the price of the underlying asset at the time of expiration. (The option expires, and the buyer loses the premium paid.)

Calculating the profit of exercising an option

If a buyer exercises the option when they are “in the money,” they have the option to either sell the stock for an immediate profit or retain their shares in anticipation of more gains. In either case, the buyer will need to have the funds available to complete the purchase upon exercising the option.

The buyer can sell the option to another buyer and take the profits before the original option expires.

The buyer must calculate the breakeven point once the strike price has been reached. If the strike price is $50, and the premium is $1 per share, the buyer will not realize a profit until the market value of the stock exceeds $51. The buyer must determine at what price exercising the option will make financial sense.

Selling a call option

The owner of a stock position can earn additional income on that investment by selling a call option. In this way, the seller will earn revenue from the premium paid by the call option buyer. If the stock price fails to reach the strike price, the option contract will expire, and the seller will keep the premium (and the stock).

Even if the option is exercised, the seller will still earn the premium revenue, as well as any dividends earned or capital gains accumulated while holding the stock before the sale.

However, if the option is exercised, the seller will not get the benefit of any additional gains in the stock price.

If you are selling a call option, you are legally obligated to sell your securities if the option is exercised by the buyer. For this reason, the seller must either own the stock, have sufficient funds to purchase the stock, or have the ability to purchase the stock on margin.

A call option in which the seller owns the underlying stock at the time the option is written is referred to as a covered call. If the seller does not own the stock at the time the option is written, the call is considered uncovered or “naked.”

Example of a call option

Suppose an investor decides to buy a call option on a stock currently trading at $45 per share, in anticipation of the price rising to $50 or more. The strike price is $50, and the buyer will pay $1 per share for the premium on the call option for 100 shares. The expiration date is set at 90 days.

After 50 days, the stock price rises to $55. The call buyer exercises the option to purchase 100 shares of the stock at $50 and immediately sells it for $55 per share. The call buyer will earn a net profit of $400 on the call option.

If the stock price never rises above $50, the call buyer will not exercise the option to purchase the stock. In that case, they will lose $100 — the $1 per share premium paid for the call option multiplied by 100 shares. The seller will keep the $100 premium paid by the buyer, as well as ownership of the underlying stock.

If the strike price is exceeded and the option is exercised, the seller will still keep the $100 premium, but forfeit any gains on the stock price above the strike price.

Call option vs. put option

While call options benefit the buyer when the price of the underlying security rises above the strike price, put options produce the opposite result. A put option becomes more valuable as the value of the underlying security falls.

Like all options, put options also have a strike price, an expiration date, and a premium. Investors make money on a put option when the price falls below the strike price. For example, if you own a put option on 100 shares with a strike price of $50, and the price falls to $40, exercising the option will create a $1,000 gain, which is the $10 decline in value times 100 shares. The premium must be deducted from these gains, so if you paid a $100 premium — $1 per share — your profit will be $900.

By contrast, if the market price of the stock is $60 when the option expires, the option will become worthless. But you’ll only be out the $100 premium.