What Is a Call Option?

What Is a Call Option?

A call option is a contract that gives you the right, but not the obligation, to buy an asset (like a stock) at a specific price (the strike price) within a certain time frame (before the expiration date). If the asset's price goes up, the buyer can profit by purchasing it at the lower strike price.

The seller, however, must sell the asset if the buyer exercises their right. If the price doesn't increase, the buyer can choose not to act, and the seller keeps the fee paid by the buyer (called the premium).

Key Takeaways

1. Call Option: A contract giving the owner the right to buy an asset at a set price within a specified period.
2. Strike Price: The agreed-upon price at which the asset can be bought.
3. Expiration: The date by which the option must be exercised.
4. Premium: The fee paid to purchase the option, which is the maximum amount the buyer can lose.
5. Usage: Call options can be used for speculation, earning income, or tax planning.

How Do Call Options Work?

Think of options as a bet:

• Buyer: Believes the asset's price will increase.
• Seller: Believes the price will stay the same or drop.

If the price rises above the strike price, the buyer can use their option to buy the asset at the lower price and sell it at the current market price for a profit. If the price doesn't rise, the buyer lets the option expire and only loses the premium.

Types of Call Options

1. Long Call Option

   • The buyer has the right to buy the asset at the strike price before expiration.
   • It’s great for planning ahead to buy at a lower price if the stock value increases.
   • Example: Traders often use long calls on dividend-paying stocks, as these stocks typically rise before the ex-dividend date.

2. Short Call Option

   • The seller agrees to sell their shares at the strike price if the buyer exercises the option.
   • Commonly used in covered calls (where the seller already owns the asset).
   • If the seller doesn’t own the asset, it’s called a naked short call, which carries more risk.

Example of a Call Option

Imagine you buy a call option for Stock XYZ:

• Strike Price: $50

• Expiration Date: 1 month

• Premium Paid: $2 per share

• If the stock rises to $60, you can exercise your option to buy it at $50 and sell it for $60, making a $10 profit per share (minus the $2 premium).

• If the stock stays below $50, you let the option expire and lose only the $2 premium.