Along with put options, call options are one of the two major kinds of options, and theyâ€™re the kind most investors think of when they hear the word â€śoption.â€ť Call options make money when a stock rises, and theyâ€™re the kind of option employees try to wrangle when they join a company, hoping the options soar in value as the companyâ€™s stock rises.
Hereâ€™s what you need to know about call options, including how to buy and sell them. (If you need a quick refresher on how options work, see thisÂ beginnerâ€™s guide to options.)
A call option is a contract that allows the owner to buy a stock at a specific price â€” called the strike price â€” by a certain future time. The buyer of the option pays the seller a fee â€” called a premium â€” for this right. If the stock price is higher than the strike price when the option expires, the call option is â€śin the moneyâ€ť and is worth money. If not, the call expires worthless.
Each option contract represents 100 shares of the underlying stock. For example, if you own five contracts, your position tracks the movement of 500 shares of the stock.
Options are a directional bet on a stockâ€™s movement and, importantly, when it will happen. A call buyer expects the stock to rise above the strike price by expiration, ideally much higher than the strike. Conversely, a call seller expects the stock to remain flat or decline over the same time. Of course, only one of these bets on the market can be correct, so the winnerâ€™s profit comes at the expense of the loser. Itâ€™s like a side bet on how the stock will perform.
Publicly traded options are standardized, meaning the details are already specified for each possible contract. You canâ€™t just go out and buy whatever option terms you want.
If you want to buy an option, youâ€™ll need to evaluate it based on the following characteristics:
Once youâ€™ve got these details sorted, you can buy or sell an option.
If youâ€™re buying a call, youâ€™ll want to consider whether the stock can finish above the strike price plus your purchase price before the option expires. If so, youâ€™ll earn a profit on the option. Even if you donâ€™t profit, as long as the stock remains above the strike at expiration, the call will retain some value. However, if the stock is below the strike at expiration, the call expires worthless.
Investors like call options because they can magnify gains massively, and you can earn gains on much more stock than you could own outright. Hereâ€™s an example of how it works, compared to directly owning the stock.
In this example, the stock is trading at $50, a call with a strike price of $55 is available for $5, and you have $1,000 to invest. Here are the profits and losses at expiration at various prices.
|Stock price||Profit/loss owning stock||Profit/loss owning calls|
With your money, youâ€™ll be able to buy 20 shares of stock, and every $5 rise in the stock translates to a $100 gain. If the stock falls $5, youâ€™ll be down $100. But the payoff profile is much different for the call options, with much higher upside and downside.
With $1,000, you can purchase two contracts (2 * $5 * 100) with a strike price of $55. For every price below $55, the contracts will expire worthless and youâ€™ll lose the whole investment. The options wonâ€™t break even until the stock is at $60 at expiration. But above that level, the calls will pay off handsomely, increasing $1,000 in value for every $5 rise in the stock price.
So thatâ€™s the attraction of buying calls â€” the possibility of a much larger gain than with the same investment in stock.
Selling (or writing) a call option is a much different proposition and makes money if the stock stays flat or declines in value at expiration. As an options seller, you want the option to expire worthless so you get to keep the entire premium.
Selling calls can be a dangerous trade because the potential upside is uncapped. The stock could simply keep rising, and the options seller is on the hook for any losses, potentially losing way more than the premium received from selling the call.
Using the same example as before, here are the profits and losses at expiration at various prices for the call seller. Note that the numbers are exactly the opposite of the call buyerâ€™s.
|Stock price||Profit/loss selling calls|
Selling $1,000 worth of call options means you can sell two contracts. For every price below the strike price of $55, the call seller will retain the entire premium of $1,000. Even if the stock goes up a bit to $57.50, the call seller will make some money. But at a stock price of $60 and above, the call seller begins to lose money quickly, $1,000 for every $5 rise in the stock price.
Selling calls can be a dangerous strategy, but thereâ€™s one variation â€” named the covered call â€” that is lower-risk and potentially even safe enough for retirees. (Here are the details.)
The biggest drawback of trading call options is the potential total loss if the stock finishes at the wrong place at the wrong time. It can become a complete loss of capital, and thereâ€™s no reset button.
And just as important as correctly predicting the stockâ€™s move, youâ€™ll have to predict the time frame too. If the stock moves higher the day after expiration, it wonâ€™t matter at all. The options will have already expired worthless. Itâ€™s like having the right lottery numbers for the wrong drawing.
Call sellers need to pay particular attention because they can lose more money than they put into a trade. Since a stock could continue rising, the call seller may lose many times more money than they receive in the premium. That could prove catastrophic.
Finally, if thereâ€™s one saving grace when buying call options, itâ€™s that even if a stock moves against you, the option often retains some value as long as thereâ€™s a lot of time left until it expires. So that allows you to close the position and not take a complete loss.
Buying and selling calls can be a very lucrative way to make money in the stock market, but itâ€™s not without important risks that should be considered before you commit any capital. Yet even more so than trading stocks, it takes an iron stomach and nerves of steel to watch options prices fluctuate, sometimes violently. Hold on to your emotions.