An agreement known as a call option provides the holder with the right to acquire stocks, bonds, commodities, or other types of securities at a certain price up until the option's specified expiration date.
Explanation of What a Call Option Is and Some Examples
A call option is a contract between two parties that grants the buyer of the call option the right to acquire the underlying security, commodity, or contract at a predetermined price within a predetermined time frame. The contract also specifies the details of this transaction, including the defined price at which it would take place (the strike price), as well as the time period for its execution (exercise date). For this privilege, the customer is required to pay an additional cost, sometimes known as a premium. Contracts for call options are typically traded in quantities of 100 shares each. The option will no longer be available after the date specified for its exercise. The buyer of a call option is not required to carry out the call's corresponding action—the actual purchase of the underlying asset—and is not required to do so. Even though the call wasn't put into action, the buyer is still responsible for paying the price. On the other side, the buyer has the right to make a request for the seller to sell the security at the agreed-upon price, and the seller must comply.How Call Options Are Put Into Action
You have the ability to either buy or sell call options depending on your projections for the price of the underlying security. You have the option to either exercise the option, choose to let it expire, or choose to sell the option contract depending on the trading strategy that you employ. If you anticipate that the value of the security may go up before the exercise date, then it makes sense to purchase a call option on the security. To give just one illustration, this is how a call option appears: Call XYZ on December 80 for 1.20 dollars. This identifies the transaction as a call option contract for XYZ stock shares, with an expiration date of December, a strike price of $80, and a premium of $1.20 per share. In most cases, the expiration date for classic options contracts is the third Friday of every month. There are various termination dates written into certain options contracts. The question now is: how do you calculate the profit for a buyer of call options? You can calculate the profit from your option trade, also known as the intrinsic value, by beginning with the price of the underlying securities if you are going to exercise your option, then deducting the strike price, the option premium, and any transactional fees from that total. In the end, whether or not an option has any "intrinsic value" is determined by the strike price. Only call options in which the buyer either exercises or lets the options expire will be taken into consideration for the purposes of this article. While selling the option contract can also result in a profitable trade, for the purposes of this piece, we will only look at call options in which the buyer exercises or lets the options expire. Take Sam as an example. Let's say he has 100 shares of XYZ, which are currently priced at $70 each. If Mary thinks that the price of a share of that stock is going to go up in the near future, then she might buy a call option that gives her the right to acquire those shares at a price of $80 per share. If Mary exercises the option before the day on which it expires and the share price reaches $90, then she will earn a profit of $10 per share. This results in a total gain of $1,000 (100 shares x $10 profit per share), which may be calculated as follows: Keep in mind that Mary gave Sam a total of $120 for the premium, which she paid in the amount of $1.20 for each share. Because of this, Mary will only end up with an overall profit of $880 ($1,000 minus $120). There is a possibility that transaction fees will further lower the net benefit.When call options make or lose money:
in-the-money calls in-the-money calls: If the option's strike price is lower than the current stock price, As was demonstrated in the preceding illustration, the increase in stock price that is subtracted from the premium and the costs associated with the transaction constitutes the call option buyer's profit. At-the-money calls: When the stock price and the strike price are equal, a call option is said to be "at the money." A buyer of call options has the option of not exercising their right to acquire the underlying shares if they determine that, after deducting the cost of the premium, the transaction would not result in a profit. Out-of-the money calls: Out-of-the-money calls occur when the price of the underlying stock goes below the option's strike price. This renders the option exercise pointless because the stock is now more expensive to purchase. The buyer will not exercise the option if the price does not increase to a level that is higher than the strike price. The only thing that will be lost is the premium. That remains the case even if there are no shares left to buy. Why would you buy a call option rather than simply purchasing shares of a stock if you believe that the share price of that stock is going to go up in the near future? One of the reasons is to reduce the possibility of suffering a loss. Let's say you spend $300 (100 shares at $3 per share premium) on a call option, and then the following week, the company declares bankruptcy. You will not take advantage of the option. Thus your total loss will be capped at $300.Offering a Call Option for Sale
The person who sells a call option is known as the writer of the option. When an investor is making a loss or is unsure about the direction of an asset, they will sell call options. Keep in mind that the seller will get the premium regardless of whether or not the call option is executed. Selling call options can be done in two different ways.Option for a Naked Call
When you sell a call option but do not hold the underlying asset, you are engaging in the practice of naked call option trading. It's a difficult choice to make. In the event that the buyer chooses to exercise the option, you will be required to purchase the asset at the current market price in order to fulfill the order. You will incur a loss equal to the difference between the current price and the strike price, less any fees that you paid for the option. Because there is no ceiling on how high the price of an asset can go, there is also no ceiling on the possible loss that you could sustain if you trade naked calls. You have to keep your fingers crossed that the price you choose covers all of the costs associated with your risk. The vast majority of companies that sell naked call options are huge conglomerates capable of diversifying their risk. Their earnings from a large number of premiums on options they correctly guess more than compensate for the infrequent losses they sustain from options trades that go against them. These companies have analysts and computer programs who figure all of this out for the companies on their behalf.Option with Covered Calls
If you are contemplating selling an asset that you already own, you should give some thought to the possibility of selling a covered call option on that asset instead. You are able to generate income without taking any risk by charging a premium for the choice. When the buyer exercises the option, you make money regardless of whether or not the strike price is higher than the amount you initially paid for the option. Because the underlying asset "covers" the option, this type of trade is referred to as a covered call. A covered call option carries with it the possibility of forfeiting gains that would have been realized if the share price rose. You will not be able to maintain a profit by selling your shares at that price. In its place, you are obligated to sell the agreed-upon number of shares to the owner of the call option at the strike price. You will be able to keep the premium, but the holder of the call option will be the one to benefit financially from an increase in the share price. There are a lot of people that write covered calls because they like the risk-free income from the premiums. A covered call can be an excellent choice for you if you already own big assets but are in urgent need of cash.Options to Call vs. Options to Put
When purchasing a put option, an investor is making the wager that the share price will fall below the strike price. The owner of a put option has the ability to sell the underlying asset at a predetermined price at any point up until the exercise date of the option. If the current price of the underlying securities is lower than the option's strike price, then the put option is profitable. The put option will no longer be profitable if the price of the underlying securities is higher than the strike price at expiration. The difference between the current price of the underlying security and the price at which the option is being exercised, known as the "strike price," is what determines the "intrinsic value" of a put option. If the price does not go lower than the "strike price," the person who holds the put option will not exercise their right to sell it. Again, the seller of a put option is entitled to keep the premium regardless of whether or not the option is ultimately exercised. The initial investment in call and put options is just the price of the premium, which means that investors can engage in contracts with only a small amount of capital. This is one of the advantages of call and put options. Trading techniques with options can involve a high level of risk and are not suitable for everyone.Key Takeaways
- An investor has the right to buy the underlying asset (which is typically shares of stock) at a fixed price (referred to as the "strike price") within a given amount of time if they purchase a call option.
- Purchasing call options is a smart financial move if you believe that the price of the underlying asset will increase in the near future.
- The purchaser of a call option is responsible for paying a premium in exchange for the right to buy the underlying shares. The buyer's loss is restricted to the amount of the premium in the event that the option is not exercised.
- A buyer can reduce their exposure to risk by purchasing options, while option sellers can increase their income by selling these contracts.
