Market swings are unavoidable and unpredictable. Even with a bullish market sentiment, it is crucial to manage risk. To that extent, there are financial avenues that help in mitigating risks.
One such avenue is call options. Call options give buyers the right (but not the obligation) to buy an underlying asset at a pre-specified price. In this article, we will discuss call options in further detail and understand how they work. The Options Clearing Corporations offers a helpful document that discusses the characteristics and risks of options, which can be found on their website.
What is a Call Option?
A call option is a financial tool that enables you to buy a specific asset at a predetermined price within a stipulated period. It gives you the right to purchase an asset without the obligation to do so. Because the value of a call option is derived from another security, they fall in the category of financial products known as derivatives.
When you purchase a call option, you are essentially securing the ability to purchase the asset at a later date (known as the expiration date) at a set price (called the strike price). This is an options strategy to have the ability to buy at a predetermined price when buyers expect a rise in the asset price.
If the asset price at expiration surpasses the strike price, the option is considered ‘in the money’ and has ‘intrinsic value,’ which is the difference between the asset’s current price and the strike price. If the asset’s price remains below the strike price or doesn’t rise significantly, the option is considered ‘out of the money’ and lacks intrinsic value.
You have to pay a premium while purchasing a call option. It is the cost of the option, which is influenced by various factors such as the current market price of the asset, the strike price, the time to expiration, market volatility, and interest rates.
In the US, options exchanges such as the Chicago Board Options Exchange and the Options Clearing Corporation are responsible for call options trading. Options traders can use standardized call options trading on different assets such as stocks, indices, and exchange-traded funds (ETFs). Individual investors, institutional investors, and hedge funds can all invest in call options.
How do Call Options Work?
A call option works by hedging your investment in favor of increasing asset prices. It provides you an option to buy the asset at a predetermined price without an obligation to do so.
Scenario 1 – the stock price goes up: If the stock price rises to, let’s say, $120 per share, you can exercise your call option. That means you can buy company X’s shares at the strike price of $110 strike price even though they’re worth $120 in the market. Your profit from this options trade is $120 – $110 – $5 (premium) = $5 per share.
Scenario 2 – the stock price goes down: If the stock price drops below the strike price of $110, you don’t have to exercise the option. In this case, you’re not obligated to buy the shares, but you lose the $5 premium per share you paid for the call option.
Long vs. Short Call Options
Call options are essentially an agreement between a buyer and a seller. They are viable only when the two have opposite expectations about the direction in which the price of an asset will move over a given period. That is the fundamental difference between a ‘long call’ and a ‘short call’ in options trading.
Long and short call options are two distinct types of trading strategies. They require careful assessment of your objectives and risk tolerance, besides thorough research on the underlying asset, market conditions, and option pricing.
How to Calculate Call Options Profit?
To calculate the profit of a call option, you need to consider the purchase price of the option, the strike price, the current price of the underlying asset, and the premium paid at the time of the transaction. You can calculate the profit by determining the difference between the market price of the underlying asset and the strike price. You need to adjust the final amount against the premium paid and transaction costs, if any.
Let’s understand it better with an example:
Why Buy a Call Option?
Investors may generally buy call options when they are optimistic about the financial market. Here are the primary scenarios where investors generally consider buying:
Why Sell a Call option?
Selling a call option may be a strategic choice when investors have a neutral to bullish market position. If you exercise an option, you must sell the underlying asset at the strike price.
Leverage Call Options Strategically
Call options may be lucrative financial instruments when traded strategically. You must, however, have a thorough understanding of the market and current trends before you start investing.
What's the difference between buying a call option vs. owning the stock?
Owning the stock means you purchased the shares of a company. Buying a call option means you can purchase a particular stock at a pre-specified price without the obligation to do so.
Can you exercise a call option without funds?
No, exercising a call option requires funds, as you need to buy the stock at the predetermined price. If you are out of funds, you can sell the option before the expiry date.
How to write covered calls and sell put options?
To write covered call options, you can sell call options of the stock that you already own. Selling put options means that you sell the right to sell the stock at a predetermined price.
What happens when call options expire?
An expired call option is worthless if they are out of money. In that case, you lose the money paid as a premium and do not make any profit. If your options are in the money, your broker can automatically exercise it to make you a profit.
What is the formula to calculate profit on a call option?
Profit on a call option is calculated as the difference between the stock’s current price and the strike price minus the premium paid for the option. You will also need to consider the stock size while calculating profit. Many online trading platforms have integrated options for profit calculators.
How to exercise a call option?
To exercise a call option, you will need to notify your broker. Your broker will facilitate the process, and if the option is in the money before the date of expiry, you’ll be required to pay the strike price per share to acquire the underlying stock.
How to close a call option?
To close a call option, you can sell it back to the market before it expires. By selling the option, you may realize any profits or limit your losses depending on the difference between the strike price and the actual stock price at the time of closing the option.
