What is a Call Option?
A call option is a commonly utilized derivative
contract between a buyer and a seller. It provides the
buyer with the right to purchase a specific asset at a
certain price within a certain time period. Here's a
look at call options.
A call option is a contract that gives a buyer the right to buy an asset by a certain date. The buyer isn’t
obligated to buy the asset, but has the choice – or option – to purchase the asset, if certain conditions
are met. The seller (known as the call writer), on the other hand, is obligated to sell the asset if the buyer
chooses to exercise his rights. Call options are commonly used with stocks, but can also be used with
bonds and other assets.
Parts of a Call Option
The call option has several components. The option premium is the amount the buyer pays for the
option. The expiration date is the date by which the option must be exercised before it becomes void.
Once the option expires, the option buyer loses the right to purchase the option at the previously
negotiated price. The strike price is the price at which the asset can be purchased before the expiration
date. The option premium takes into account four different factors: the current stock price, the amount of
time until the option expires, the volatility of the market, and the strike price. The intrinsic value of the
option is the difference between the stock’s price and the strike price.
Making Money With Call Options
A call option is in-the-money when the current price of the asset is above the strike price. For example, if
a stock’s strike price is $40 and the stock’s current price is $45, then the call would be in-the-money.
(The intrinsic value is $5 in this example.) A call option is out-of-the-money when the stock price falls
below the strike price. The option isn’t profitable if the stock price doesn’t rise above the strike price. It’s
worthless if the stock price falls below the strike price. If the option becomes worthless, the seller isn’t
obligated to comply with the contract.
Why Purchase Call Options?
The call writer initially makes money when the call option
is sold. But, the buyer purchases a call option hoping the
value of the stock goes up before the option expires.
This gives the buyer the opportunity to purchase the
stock at a lower price, sell it at a higher price, and make
Buyers don’t always have to sell the underlying stock to
make money. Instead, the buyer can sell the call option
itself, which increases in value as the stock price
increases, and make a profit. However, if the stock value
doesn’t go up or it drops, the buyer loses the money he
paid for the option premium.
The call writer, on the other hand, hopes the stock price doesn’t rise before the option expires. In that
case, the call writer keeps the contract premium as profit. But, the call writer loses money if the stock
price rises and the buyer exercises his call option.
For example, assume a buyer pays a $200 call premium to purchase 100 shares of stock at $40 by April
21. (Note: one stock option is 100 shares of stock.) The stock price rises to $45 on April 10 and the
buyer chooses to trade out his position. If the call writer doesn’t already own the stock, he must purchase
100 shares of the stock at $45 ($4,500) and sell them for $40 each ($4,000) taking a $300 loss (after the
$200 received premium).
If the call buyer sells the stock for $4,500 after purchasing it for $4,000, he’d receive a $300 gain (after
the $200 premium).
But, if the stock price dropped to $38, the option becomes worthless and the buyer loses the $200
option premium he paid. The call writer, on the other hand, is $200 richer.
Options investing involves risk and is not suitable for all investors. It is possible for an options investor to
lose the entire amount committed to options in a relatively short period of time. Copies of the Options
Disclosure Document are available upon request by calling your representative or by contacting the
Options Clearing Corporation at 1-800-678-4667. You may also visit their website www.theocc.com.
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