Call Option Definition & Uses

DailyForex.com Team

Call Option

Call options can help you earn if your prediction about how a stock will transition comes true.

When people speak about options and options trading, they are usually talking about strategies that can be applied to buying and selling calls and puts.

Today, let me give you an overview of why shareholders transact call options on shares and how that differs from holding stocks directly.

Call Option: Definition, Calculation, and How-to

This comprehensive article is designed to give readers an understanding of what a call option is, how to use it and how to calculate it.

Call Option Definition

Call options serve as types of financial agreements, which offer the options investors the ability, but not the commitment, to purchase a share, bond, product, and other resource or device at a certain price during a certain timeframe.

The underlying security is the stock, commodity, or bond. A buyer of calls makes money when the value of the underlying goes up. A put option, on the other hand, gives the shareholder the ability to sell the asset at a certain premium on or prior to the option's expiration date.

Key highlights

  • A call is defined as an option contract that gives the holder the right, but not the responsibility, to buy a certain quantity of an underlying asset at a certain price within a certain period.
  • The price you choose is called the strike price. The time you choose to sell it is called the time to maturity or its expiration.
  • When you buy a call option, you pay fees called the premium. That's the most you can end up losing per share on the call option.
  • You can purchase a call option for the long term or sell it within a short span.
  • Call options can be bought to make a bet or sold later to generate money or manage your taxes.
  • Options on calls can also be used together as part of spread and combination strategies.

How Does Call Options Work with Examples?

Call options are a form of derivative contracts that give the shareholders the right and not the committment to purchase a certain amount of stocks at a certain price, called the option's "strike price."

If the market value of the stock goes up above the strike price of the option, the person who owns the option can use it to make a profit by purchasing the shares at the strike rate and selling it at an increased market price.

Options, on the other hand, only stay valid or a specific certain amount of time. During that time, if the market rate doesn't soar beyond the strike price, the options are valueless.

Example

Let's say that stock is the underlying asset. Call options let the owner purchase 100 shares of companies at a certain price, called the "strike price," until a certain date, called the "expiration date."

For instance, a certain call option could give the investor the choice to acquire number of shares of Apple stocks at $100 each until the contract expires 3 months later. Market participants can choose from a number of expiry dates as well as strike prices.

The valuation of the contract goes up as the worth of Apple stock rises, and vice versa. The person who buys a call option can keep the contract only until expiration date.

At a certain period, they could take possession of those 100 shares or sell the contract at any point prior to its expiration at the market rate of the agreement at that specific time.

When you buy a call option, users pay a fee. This fee is called the premium. It is the cost of getting the entitlement which the call option gives.

If the underlying security is worth less than the strike price at the end of the contract, the call purchaser ends up losing the premium they paid. This is the most you could lose.

If the existing market value of the asset is higher than the strike price when the option expires, the income or profit is calculated by substracting prices from the premium. The number of shares that the option buyer owns is later multiplied by this amount.

For instance, if Apple is dealing at $110 at the end of the agreement, the strike price of the option contract is $100, and the buyer paid $2 per share for the option, the profit is $110 minus $100 plus $2, which is $8.

If the customer purchased 1 options contract, they would make $800 ($8 times 100 shares). If they purchased 2 contracts, they would make $1,600 ($8 times 200 shares).

Now, if Apple is trading for less than $100 when the option expires, the buyer won't use the choice to purchase shares at $100 each, and the option becomes worthless.

The customer loses $200 for every contract they bought, which is equal to $2 per share. That's the great thing about having choices: if you make a decision not to play, you only lose the premium.

When is Call Option Used?

Call options are often used for three main things: making money, gambling, and lowering taxes.

When you sell call options, there are a few things you need to keep in mind. If you want to trade, make sure you completely recognize the value and profitability of an option contract. If you don't, you risk the stock going up too much.

Getting money from options

Some shareholders use a method called "covered calls" to make money with call options. In this tactic, you have an underlying stock and give somebody the choice to acquire your stock by composing a call option.

The investor gets the premium and then hopes that when the option expires, it won't be worth anything (below strike price). This strategy gives the investor more money, but it could also limit the amount of money they can make if the value of the underlying stock goes up quickly. 

Covered calls perform because the person who bought the option will use their right to purchase the shares at the reduced strike rate if the stock price goes above the strike price.

This means that if the stock goes above the strike price, the options trader doesn't make any money. The premium is the most the option writer can make from the option.

Using options to make guesses

Options contracts allow buyers to get a lot of access to a stock for a small amount of money. When used alone, they can make you a lot of money if a stock goes up.

But they might also lead to a loss of the entire premium if the underpinning stock price doesn't rise beyond the strike rate before the call contract expires. When you buy call options, the most you can lose is the amount you spent on the option.

A call spread is made when investors purchase different call options at the same time.

These put a limit both on prospective profits and losses of the strategic plan, but they can be cheaper than a solitary call option in certain cases since the premium from selling one option pays for the premium from buying the other.

Managing taxes

Investors often use options to transform the way their portfolios are divided up without having to buy or sell the underlying assets.

For instance, a shareholder could own a number of shares of ABC stock and be responsible for a large unacknowledged capital gain.

Stockholders could use options to decrease their visibility of the underlying asset without selling it, so as not to cause a taxable event. In the example above, the one and only cost this tactic has for the shareholder is the price of options contracts.

Even though profits from options will be counted as short-term investment income, the way to figure out how much tax to pay will depend on the exact approach and holding period.

What Are the Types of Call Options?

There are two different kinds of call options.

Long call option

A long call option is just a basic call option wherein the purchaser has the entitlement, but not the commitment, to purchase shares at a future strike price.

It is helpful because it lets you make plans to buy a stock at a lower price. For instance, you could buy a long call option in preparation for something newsworthy, like a firm's earnings call.

With a long call option, you can make as much money as you want, but you can only lose the premiums.

So, even though the company doesn't report a better-than-expected earnings report (or one that meets growth forecasts) and the valuation of its shares goes down, the purchaser of a call option will only lose as much as the premium they paid for the option.

Short call option

A short call option is the reverse of a long call option, as its name suggests. Here, the person selling the option pledges to sell their shares in the coming years at a set strike price.

They are mostly used for "covered calls" by the person selling the option. This means that the person selling the option already owns the stock that the option is based on.

The call helps them limit their losses if the trade doesn't go the way they want. For instance, their losses would grow if they didn't own the stock that their option was based on and the price of that stock went up a lot while they still had the option.

How to Calculate Call Payoff Option?

Call option payoff is the amount of money that the person who bought or sold the option makes or loses from the trade. When assessing call options, keep in mind that the strike price, expiry date, and premium are the 3 most important things to think about.

These factors are used to figure out the payouts from call options. Call options can pay off in two ways.

Payoffs for people who buy call options

Let's say you pay $2 extra for a company (ABC) call option. Its strike price is $50 — which will end on November 30. If ABC's stock price goes up to $52, which is the total of the fee you paid and the stock's purchase price, you'll get back what you put into it.

Any amount over that is regarded as a profit. So, there is no limit to how much money can be made when the valuation of ABC's shares goes up.

What will happen if the price of ABC's shares falls below $50 by November 30?

Because your options contract gives you the right, but not the responsibility, to buy shares of ABC, you might choose not to exercise it, which means you won't buy any of ABC's shares. In this scenario, the most you can lose is the amount you spent on the option.

  • Payoff = spot price - strike price
  • Profit = payoff - premium paid

If ABC's spot rate is $55 on November 30, and you use the above formula, your profit is $3.

Payoff for people who sell call options

For a call option, the seller's calculations for how much they will get back are not really different. If you offload an ABC contract at the same strike rate and expiration, you will only make money if the price goes down.

Your damages could be confined or unrestricted, based on whether the call is protected or not. In the second case, the buyer of the options can exercise the contract and force you to buy the underlying security at spot rates (or maybe even more).

In this particular instance, the premium you get when the options contract ends is the only way you can make money (and make a profit).

Here are the formulas to figure out payoffs and profits:

  • Payoff = current price minus the strike price
  • Payoff plus premium = profit

Using the above formula, if ABC's spot rate is $47 on November 30, you will make $1.

Call Option vs Put Option: What’s the Difference?

A put option is another major type of option. Its value goes up as the price of the stock goes down. By buying put options, traders can bet on a stock going down. Put options are the reverse of call options in this way, but they have many of the same risks and rewards:

  • Like when you buy a call option, when you buy a put option you have the chance to get back many times what you put in.
  • When you buy a put option, like when you buy a call option, a risk is that you'll lose all of your invested capital if the put option expires without any value.
  • When you sell a put option, you get paid a premium, just like when you sell a call option. However, if the trade goes in an unfavorable direction, the merchant carries all the risks.
  • If you sell a put option instead of a call option, you can't lose more than $0 (since a stock can't go below $0). Still, you might lose a lot more than the amount of the premium.

Why Is Call Option Popular?

Investors like call options since they can help them reach different goals. One thing that makes investors want to make assumptions is that they can make the impacts of price movements bigger. But options can be used in many other ways, like:

Limit taking risks and make a capital gain at the same time. People often think of options as dicey, but they also can be used to reduce risk or protect a position. For instance, an investor who wanted to make money from the rise.

Make money off of the premium. Investors can make money by selling call options, which is a good idea when accomplished in moderate amounts, like with a safe trading plan like "covered calls."

Getting incremental returns can be a good idea, especially when the market is flat or a bit down and the stock isn't really likely to be called.

Get better deals for their equities when they sell them. Some investors utilize call options to get better prices for their stocks when they sell them. They can sell options on shares they want to sell but that can be too cheap at that moment.

If the price goes up above the strike price of the call, they could sell the shares and keep the fee as a bonus. If the stock stays underneath the strike rate, they could keep the fee and attempt the tactic again.

Conclusion

Options can indeed be risky, but there are smart ways for traders to use them. In reality, if you are using options the right way, you could limit your uncertainties while still making money from a stock's gain or loss. Of course, options also give you the chance to attempt for a home run when you still want to.

FAQ’s

What happens if my call option expires in the money?

Whenever a call contract expires in the funds, the strike rate is cheaper than the price of the underlying asset. This means the trader who owns the contract makes money. For put options, it's the other way around, so the strike value is higher than that of the price of the underlying security.

What is a naked call option?

A naked call is that when an option to buy a call is sold on its own, without any other positions to balance it out. Once call options are traded, the person who sells them makes money when the price of the underlying protection goes down.

A naked call does have a limited chance of making money on the upside and, in theory, an unlimited chance of losing money.

How to close a call option?

Sell to close is a trade order for options. It means to get out of an options contract by selling it.

There are three ways to end an options contract:

In call options, sell to close happens when the expiration price of the underlying asset is lower than the strike price.

The options contract is utilized, when the expiration price of the underlying asset is higher than the strike price. 

The options contract is sold on the market (called "sell to close") before it expires.  When an owner sells to shut an options contract, s/he gives the contract to someone else who is involved in the market. Based on the price of the contract at the execution time, an investor can make or lose money on a sell-to-close trade order.

What happens when a call option hits the strike price?

If you have a call option, you would like the market rates to go up until the time the contract expires. When the strike price is met, your contract is basically worthless when it runs out.

What is the limit price on a call option?

With a purchase limit order, you could fix a limit price, that should be the most you are ready to pay for the contract. The agreement will only be bought at a price that is lower than your limit price. With such a sell limit order, users can place a limit price, that should be the least amount you want to get for a contract.

DailyForex.com Team
The DailyForex.com team is comprised of analysts and researchers from around the world who watch the market throughout the day to provide you with unique perspectives and helpful analysis that can help improve your Forex trading.

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