Call options are the type of option that increases in value as the price of the underlying stock increases. They are the most well-known type of option, allowing the owner to lock in a price to purchase a specific stock by a specified date. Call options are attractive because they can appreciate rapidly in response to a slight increase in the underlying stock price. As a result, they are traders’ favourites seeking a significant profit.

What is a call option?

A call option provides the right, not the commitment, to acquire a stock at a set price (strike price) by a predefined date at the expiration of the option. The call buyer will pay a premium for this right, which the call seller will receive. Unlike stocks, which can exist in perpetuity, an option will expire and be of paltry importance or have some value.

The following components are an option’s primary characteristics:

  • Strike price:

    The price where the underlying shares can be purchased.

Premium:

The cost of the option, payable by either the buyer or the seller.

When an option matures and is settled

A contract is an option, and each contract represents one hundred shares of the stock. Exchanges quote option prices in terms of the price per share, not the overall cost of ownership. For instance, an option may be quoted on the exchange at $0.75. Thus, it will amount to (100 shares * 1 contract * $0.75), or $75, to purchase one contract.

The operation of a call option

When a stock price is greater than the strike price at expiration, the call option is “in the money.” The call option owner may exercise it by putting up cash to purchase the stock at the strike price. Alternatively, the owner might sell the option to another buyer at its fair market value before it expires.

The call owner benefits when the premium paid is less than the difference between the stock price and the strike price. For instance, suppose a trader purchased a call for $0.50 with a strike price of $20, and the stock is trading at $23 at expiration. The option is worth $3 (the $23 stock price less the $20 strike price), and the trader has profited by $2.50 ($3 less the $0.50 fee).

If the stock price is less than the strike price at the expiration time, the call is “out of the money” and becomes worthless. The call seller retains any premium received for the option.

Why would you purchase a call option?

The primary benefit of purchasing a call option is that it magnifies the gains in the price of a stock. You can profit on a stock’s gains above the strike price until the option expires for a minimal upfront investment. Therefore, if you purchase a call, you typically anticipate the stock to climb before expiration.

Assume that the stock LMN is trading at $20 per share. For $2, you can purchase a call option on the stock with a $20 strike price that expires in eight months. Each contract costs $200, or $2 * 100 shares * 1 contract.

The trader’s profit at expiration is shown below.

As you can see, for every dollar gain in the stock price above the strike price, the option’s value (upon expiration) increases by $100 as the stock goes from $23 to $24 — a gain of only 4.3 per cent – the trader’s profit is x2 from $100 to $200.

While the option may have been in profit at expiration, the trader may have lost money. Because the premium is $2 per contract in this example, the option becomes profitable at $22 per share, the $20 strike price plus the $2 premium. The call buyer earns money only over that level.

If the stock closes between $20 and $22, the call option retains some value, but the trader loses money overall. Furthermore, if the share price falls below $20, the option expires worthless, and the call buyer forfeits the entire investment.

The appeal of buying calls is that they significantly increase a trader’s profits compared to directly owning the stock. A trader can purchase ten shares of stock or one call for the exact initial cost of $200.

If the stock reaches $24, then…

The stock investor earns a profit of $40, or ten shares multiplied by the gain of four dollars.

The options trader earns $200, or the $400 option value (100 shares * 1 contract * $4 strike price) less the $200 premium paid for the call.

In percentage terms, the stock returns 20%, whereas the option returns 100%.

Why would you sell a call option?

Each call purchased results in a call sold. Therefore, what are the benefits of selling a call? In summary, the payoff structure for buying a call is the inverse of the payout structure for selling a call. Call sellers anticipate that the stock will remain flat or decrease, and they want to bag the premium with no fallout.

Let us return to the previous example. Assume that the stock LMN is trading at $20 per share. For $2, you can sell a call option on the stock with a $20 strike price that expires in eight months. One contract is worth $200 ($2 * one contract * one hundred shares).

The payout schedule is the polar opposite of the call buyer’s:

Each time the price falls below the strike price of $20, the option expires with no value, and the call seller retains a $200 cash premium.

Between $20 & $22, the call seller retains some, but not all, of the premium. Beyond the $200 premium obtained, the call seller loses money above $22 per share.

The appeal of selling calls is that you earn a cash premium beforehand and are not required to make any immediate payments. Then you wait till the maturity of the stock. If the stock falls, remains flat, or slightly climbs, you will earn profit. However, unlike a call buyer, you won’t be able to quadruple the money. As a call seller, the maximum amount of profit you can earn is on the premium.

While selling a call appears to be a low-risk strategy – and it frequently is — it could become one of the riskiest options strategies due to the possibility of limitless losses if the stock climbs. Ask traders who sold call options on GameStop stock in January and lost a small fortune in a matter of days.

For instance, if the stock doubled in value to $40 per share, the call seller would lose a net $1,800, or the option’s $2,000 value less the $200 premium received. However, several safe call-selling tactics, such as the covered call, can be used to aid in the seller’s protection.

Options on-call vs options on put

The other primary option type is the put option, which increases in value as the stock price falls. Thus, traders can bet on the reduction of stock by purchasing put options. In this way, puts are the stark opposite of call options, although they carry a lot of the same risks & rewards:

As with buying a call option, buying a put option enables you to earn many times the initial investment.

As is the case with purchasing a call option, the risk involved is that you may lose your entire investment if put expires worthless.

As with writing call options, selling put options generates a premium, but the seller assumes the complete risk if the underlying stock moves in a negative direction.

Compared to selling a call option, selling a put option exposes you to limited losses (since a stock cannot fall below zero). Nonetheless, you risk losing many times the amount of the premium obtained.

Additional information is available on everything you need to know about put options.

In conclusion

While options are hazardous, traders can utilise them prudently. Indeed, when used properly, options can help mitigate risk while still allowing you to profit from a stock’s gain or loss. Of course, if you still wish to go for the home run, choices provide that option as well.