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Call Options - Definition
Call Options are stock options that gives its holder the
POWER, but not the obligation, to BUY the underlying stock at a FIXED PRICE by a fixed EXPIRATION DATE.
Call Options - Introduction
Call Options are definitely the more popular of the 2 kinds of stock options. The other being
Put Options that gives you the right to sell the
underlying stock for a fixed price. Call Options enable you to buy the underlying stock at a price fixed right now no matter how
high it rallies in future for just a small price relative to the price of the
underlying stock. Call options give you the power to profit from
a rally in its underlying stock for just a very small price without first having to buy the underlying stock! Apart from being an incredibly flexible
and risk limited leverage instrument, Call Options are fantastic
hedging instruments for any stock portfolios.
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Manipulated properly, Call Options
allows anyone to profit from any move in the underlying stock, take advantage of new trends or swings very quickly and hedge away financial risks.
Small retail investors use Call Options as speculative instruments to turn a big profit from very small amounts of money and big institutional
investors use Call Options to protect their stock portfolios and to increase marginal revenue. In fact,
employee stock options are Call Options too. Such widespread application and flexibility
makes learning about how Call Options work, one of the most important investment knowledge of modern times.
How Do Call Options Work?
Call Options are financial contracts between a buyer and a seller. The seller or "writer" of Call Options is giving the Buyer of those Call Options
the right to buy his stocks at a price fixed and agreed upon in the Call Options contract. The buyer or "holder" of these Call Options can now
hold on to them, hoping that the stocks will rise in price over time, before the Call Options contract expires, and then either sell the
Call Options on to another buyer at a higher price or
exercise the right vested in the Call Options to buy the stock from the seller at the
lower agreed price, turning around for a profit by selling those stocks in the open market.
Clearly, the seller or "writer" of Call Options is expecting his stocks to stay stagnant or to go down. Since the seller expects his stocks
to go down, selling Call Options on those stocks actually results in additional income, offsetting the expected drop in the stocks if he is
right. This hedges the risk of owning those stocks without having to sell the stocks.
The buyer of those Call Options is clearly expecting those same stocks to go up and is willing to pay a small price to speculate on such a move.
This expectation is also captured in the popular investor sentiment indicator known as
Put Call Ratio. Put Call Ratio is the ratio of the amount of
put options traded versus call options traded.
Parties in Call Options Transaction
Here's an example of what happens in a Call Options transaction:
Call Options Example:
XYZ company shares are trading at $40 right now. $40 strike price Call Options are trading at $2.00.
John bought 100 shares of XYZ company at $30 1 week ago and expects XYZ company shares to pullback a little after such a strong rally.
He decided to hedge his position of XYZ stocks by selling 1 contract (representing 100 shares) of $40 strike price Call Options. He makes
$200 from the sale of the Call Options, which would cover his losses should shares of XYZ company fall by less than $2.00 and actually adds to
his profits if XYZ company shares remain stagnant at $40 when the Call Options expire.
Peter is of the opinion that XYZ company shares will continue to rally strongly. He wants to take advantage of the rally and don't want
to pay $40 per share doing it. He decided to buy the $40 strike price Call Options for only $200 ($2.00 x 100), controlling 100 shares. To
control 100 shares, he would normally have to pay $4000 ($40 x 100) to own the stocks but with Call Options, he is doing it only at $200, which is
only 5% of the usual price!
Scenario 1 : XYZ Rallies To $70 During Expiration Of The Call Options
John's XYZ shares was called away by the buyer of his Call Options at $40. He made a total profit of $40 - $30 + $2 = $12 in total from this trade.
Peter's $40 strike price Call Options are now worth $30 as it allows him to buy XYZ shares at $40 when it is trading at $70 now. He made a
total profit of $30 - $2 (the price of the Call Options) = $28 per contract or 1400% profit!
Scenario 2 : XYZ Falls To $38 During Expiration Of The Call Options
John's XYZ shares' loss of $2 per share in value which is completely offsetted by the sale of the Call Options for $2 per share. John loses nothing
in this trade.
Peter's XYZ shares expires worthless as there is no value in the right to buy XYZ shares at $40 when it is trading at $38 now. Peter loses the
$200 he used in buying those Call Options.
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Call Options - Terminology
Strike Price
The price at which you can buy shares of the company no matter how far it has moved in the future.
Holder
Owners of Call Options. You are the holder of your Call Options.
Writer
Sellers of Call Options. You are a writer when you initiate a position by selling Call Options. This is called
Sell To Open. Learn More About The
Types Of Options Orders.
Exercise
To initiate the right to buy the underlying stock at the strike price.
Expiration date
The date by which you must exercise the right to buy shares of the company or let the Call Options laspe worthless.
In The Money
When the shares of the company is higher than the strike price. Read more about
In The Money Options.
At The Money
When the shares of the company is the same as the strike price. Read more about
At The Money Options.
Out Of The Money
When the shares of the company is lower than the strike price, making the Call Options worthless upon expiration. Read more about
Out Of The Money Options.
Call Options And Time Decay
Call Options contracts come with a price. That price acts as an "insurance premium" to the buyer and a form of compensation to the writer for
taking on the extra risk. The longer the expiration date of the Call Options, the higher this price is due to the extra risk the writer is
facing. This price is known as the "extrinsic value". As extrinsic value of stock options in general is a function of how
long the period of risk the writer is facing governed by the expiration date, it reduces as expiration date approaches. This reduction in
value over time is known as Time Decay and is governed mathematically by the
Option Greek known as Theta.
Holders of Call Options
need to be aware that if the underlying stock fails to move up quickly and hopefully overtaking the price paid on the Call Options, those
Call Options would reduce in price daily due to time decay. Writers of Call Options need to be aware of whether or not the extrinsic value
of the Call Options that you wish to write justifies the additional risk or fulfills your hedging objectives.
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Please note that this is the practise in the United States. Different countries could have different regulations.
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Applications Of Call Options
There are 2 primary investment functions of Call Options; Leveraged Speculation and Hedging.
Leveraged Speculation
Stock options are great leverage tools that not only produce leveraged, unlimited profits but also limited losses. Call Options are
stock option's solution to providing leveraged returns on rising stocks. Call Options allow its holder to benefit from the same
profit in the underlying stock using only a small fraction of the money. Such leverage can be calculated and applied strategically
to any portfolios.
Read About How To Calculate Options Leverage. As
you can see in the previous example, Peter, who bought call options on XYZ shares, made 1400% profit when XYZ shares rallied from $40 to $70
while John, who bought XYZ shares, made only 75% profit. Call Options leverage can be used either to aggressively return a higher profit on the
same amount of capital or to conservatively generate the same profit as you would buying the underlying stock using only a small fraction of the money.
Call Options Aggressive Example:
XYZ company shares are trading at $50 right now. $50 strike price Call Options are trading at $2.00.
You have $5000 as capital.
Instead of buying only 100 shares, you could now buy 25 contracts ($5000 / $200) of its $50 strike price call options representing 2500 shares
using your $5000 capital.
Assuming XYZ Shares rally to $70.
Instead of making only $2000 (($70 - $50) x 100) profit, you would have made $45,000 ((($70 - $50) x 2500) - $5000) profit from the Call Options using
the same $5000 capital.
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In the options trading example above, you would have made 22 times more profit on the same move using call options than you would buying the stock.
Call Options Conservative Example:
XYZ company shares are trading at $50 right now. $50 strike price Call Options are trading at $2.00.
You have $5000 as capital.
Instead of spending the whole $5000 capital to control 100 shares, you could control 100 shares by purchasing 1 contract of its call options
for only $200 ($2.00 x 100).
Assuming XYZ Shares rally to $70.
Shares made $2000 (($70 - $50) x 100) profit. Your Call Options also made $1800 net profit after deducting the $200 in initial outlay.
While you have to put your entire $5000 capital at risk to capture that $2000 in profit using stocks, you could risk only $200 for the same profit.
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By risking only 4% of your capital, you could capture the same amount of profit using call options.
This is known as a Fiduciary Call option strategy.
Hedging
Like stock futures, stock options were initially created as hedging instruments. Today, Call Options are still used as hedging instruments by
investment institutions and funds. Call Options can be shorted to hedge against a pullback in long stock
portfolios and can be longed to hedge against a lift in short stock portfolios. Apart from that, Call Options can also be creatively longed or shorted
to hedge against any kind of options strategies.
Call Options produce hedging through
Delta Neutral as well as
Contract Neutral hedging.
Call Options Trading Strategies
There are many options trading strategies involving the use of Call Options. Here are some of them:
Fiduciary Calls
Replace stocks with a corresponding amount of call options in order to reduce capital outlay.
Bull Call Spread
Profits from a moderate rise in the underlying stock by having short call options cover the cost of long call options.
Calendar Call Spread
Profits when the underlying stock rises moderately or remains stagnant through buying and writing call options of different expiration dates.
Naked Call Write
Profit when the underlying stock remains stagnant or drops moderately by shorting Call Options.
Stock Replacement Strategy
A famous trading strategy made popular by Jim Cramer. Uses Deep In The Money call options and strategic hedging in order to
reduce risk and volatility while returning a higher profit.
See a full List Of Options Strategies.
Call Options can also be combined with stocks to create put options synthetically without closing the call options position. It can
also be used to transform stock positions into call options or put options synthetically without closing the original stock position.
This is known as Synthetic Positioning.
Pricing Of Call Options
The price of Call Options consists of 2 components. The intrinsic value and the extrinsic value. Intrinsic value is the amount of profits
already built into the call options while the extrinsic value is the price you pay just to own the options contract as a compensation to the
seller or writer for the extra risk. When you purchase At The Money options, where the strike price of the call options is exact the same as
the prevailing price of the stock, or Out Of The Money Options, where the strike price of the call options is higher than the price of the
prevailing price of the stock, the price of the call options would consist of only extrinsic value.
Call Options Pricing Example:
XYZ company shares are trading at $50 right now.
$50 strike price Call Options are trading at $2.00.
$51 strike price Call Options are
trading at $0.50.
$49 strike price Call Options are trading at $2.80.
The $50 strike price call options consists of $2.00 extrinsic value and no intrinsic value as there are no profits built into them yet. This is
known as At The Money.
The $51 strike price Call Options consists of $0.50 extrinsic value and no intrinsic value as the stock needs to rise beyond $51 to make a profit.
This is known as Out Of The Money.
The $49 strike price Call Options consists of $1.80 extrinsic value and $1.00 intrinsic value as the options allows the stock to be bought
at $1 lower than the prevailing price. The value of $1 is captured as
intrinsic value. This is known as
In The Money.
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As you can see from the above example, the price of call options is affected mainly by where it's strike price is in relation to the price of
the underlying stock. This is known as Options Moneyness and is the most important concept to understand in options trading. Read more about How Stock Options Are Priced. Trading Call Options of different strike prices produces very different results on the same move in the
underlying stock. To learn these different considerations,
please read the Long Call Options strategy.
Call Options Chains
Stock traders obtain the price of a stock through a Stock Quote, Option Traders obtain the price of a call option through an
Option Chain.
Call options chains list all call options available on a stock across all strike prices. Here is how typical options chains looks
like:
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XYZ Company, $50, Expiration : Dec 2007
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Symbol
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Strike
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Last
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Bid
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Ask
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Volume
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Open Interest
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.xyzhg
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$51
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$0.50
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$0.30
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$0.50
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1000
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50
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.xyzhh
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$50
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$2.00
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$1.80
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$2.00
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3000
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1000
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.xyzhi
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$49
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$2.60
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$2.60
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$2.80
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50
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5
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Symbol : Every call options are identified uniquely with their own names or representations.
Strike : The strike price of each individual call options.
Last : The last transacted price of that particular call options contract.
Bid : The price at which you can sell a particular call options contract at.
Ask : The price at which you can buy a particular call options contract at.
Volume : The number of transactions that took place for each individual call options contract for the day.
Open Interest : The number of open positions floating in the market for each individual call options contract.
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Last price data is not as meaningful in options trading as it is in stocks trading. Stocks can only move in price when a
transaction takes place and that price is reflected in its last price. This means that, for stocks, the last price is
representative of the fair market value of the stock at the prevailing point in time. However, options do not need any
transactions to take place for its value to move. Its value changes as long as the underlying stock price changes.
This makes its last price a very useless piece of information as the price of the option might have moved quite a bit from
the last time it got transacted. That is why options traders only look at the bid and ask price during options trading.
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You get to choose from different expiration months (the month on top) and from different strike prices.
Each of these strike price allows you to buy the underlying stock at the strike price no matter what price the stock is in the
future. If you buy the $49 strike
call option (known as the December 49 Call) for $2.80 (yes, you always buy at the "Ask" price and sell at the "Bid" price), you get to buy the
XYZ Company shares
at $49 at anytime even is it is trading at $50 now.
Of course, you will never make any money by buying the December 49 call option now, exercising the call option,
buy XYZ company shares at $49 and then selling it immediately at its prevailing price of $50.
Why? Because you would make only $1 out of that sale while you would have paid $2.80 to buy that call option contract.
Yes, that difference in price, known as the extrinsic value,
has already been priced into the call option and that is why you can see
from the chains above that it gets more and more expensive as the call option strike price becomes lower and lower.
Learn More About Volume And Open Interest Of Stock Options.
Get free options chains here.
Where Can You Buy Call Options
You can trade call options of any optionable stocks online through the internet simply by opening an account with
any online options trading brokers. Call Options are
also trade in Over The Counter (OTC) markets or what is known as pink sheets for stocks that do not have exchange traded options. However,
these markets are not generally accessible to the public. Exchange trade options are stock options that are publicly traded in the exchanges
just like stocks.
Benefits Of Call Options
Potential for greater profits using the same amount of money.
Makes the same profit as stocks using only a small fraction of the price.
Can be used to hedge against stock or options trading positions.
Extremely flexible. Can emulate payoff of stocks or put options through synthetic positions.
Disadvantages Of Call Options
Expires worthless if the stock trades below strike price by expiration.
Call Options Questions
What is the formula to calculate call and put options price?
Do I have to exercise to take profit on call options?
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