Call Options explained
One of the easiest options to understand are call options? When you buy an option it is called getting long call. A call option is an option contract in which the buyer has the right to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.
A call option is defined by the following 4 characteristics:
- There is an underlying stock or index
- There is an expiration date of the option
- There is a strike price of the option
- The option is the right to BUY the underlying stock or index.
Long Call Options
A call option is called a “call” because the owner has the right to “call the stock away” from the seller. It is also called an “option” because the owner has the “right”, but not the “obligation”, to buy the stock at the strike price. In other words, the owner of the option (also known as “long a call”) does not have to exercise the option and buy the stock–if buying the stock at the strike price is unprofitable, the owner of the call can just let the option expire worthless.
Are Call options attractive?
People think that the most attractive characteristic of owning call options is that your profit is technically unlimited. And your loss is limited to the amount that you paid for the option. Look at this call options payoff diagram and you will see what I mean. This diagram shows the payoff for owning call options with a strike price of $40 and a cost of $2. You will notice that if the stock price closes at or below $40, you lose the $200 ($2 price times 100 shares) cost of buying the option (note the horizontal line intersecting the y-axis at -$200). You will also notice that as the stock price increases above $40 the line slopes up indicating your profit. Finally, notice that the up sloping line become profitable at break even $42, which is the strike price of $40 plus the $2 cost of buying the option. Theoretically the stock price can go to infinity so that is why they say the earnings from owning a call option are unlimited. You only start to profit when the stock price is above your break even. It expires worthless when the stock price is below the break even at expiration. We rather like to sell options and collect the options premium if the option expire worthless.
Alternative to Call Options
Imagine that you think the price of the stock will go up. Instead of buying a call and waiting that the stock moves above the break even you can also a sell a put option. You will receive the option premium and keep it when the stock price is above the strike price. If you like this trade you also want to know how to trade put options.