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Term: Call Option

21 Jul 2018

What is a ‘Call Option’

Call options are an agreement that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset.

A call buyer profits when the underlying asset increases in price.

Breaking Down the ‘Call Option’

Call options give the holder the right to buy 100 shares of an underlying stock at a specific price, known as the strike price, up until a specified date, known as the expiration date.

For example, a single call option contract may give a holder the right to buy 100 shares of XYZ stock at \$100 up until the expiry date in three months. There are many expiration dates and strike prices for traders to choose from. As the value of XYZ stock goes up, the price of the option contract goes up, and vice versa. The call option buyer may hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock or sell the options contract at any point before the expiration date at the market price of the contract at that time.

The market price of the call option is called the premium. It is the price paid for the rights that the call option provides. If at expiry the underlying asset is below the strike price, the call buyer loses the premium paid. This is the maximum loss.

If the underlying’s price is above the strike price at expiry, the profit is the current stock price, minus the strike price and the premium. This is then multiplied by how many shares the option buyer controls. For example, if XYZ is trading at \$110 at expiry, the strike price is \$100, and the options cost the buyer \$2, the profit is \$110 – (\$100 +\$2) = \$8. If the buyer bought one contract that equates to \$800 (\$8 x 100 shares), or \$1,600 if they bought two contracts (\$8 x 200).

If at expiry XYZ is below \$100, then the option buyer loses \$200 (\$2 x 100 shares) for each contract they bought.

Call options are typically used for three primary purposes. These are tax management, income generation, and speculation.

Options Used for Tax Management

Investors sometimes use options as a means of changing the allocation of their portfolios without actually buying or selling the underlying security. For example, an investor may own 100 shares of XYZ stock and be sitting on a large unrealized capital gain. Not wanting to trigger a taxable event, shareholders may use options to reduce the exposure to the underlying security without actually selling it. The only cost to the shareholder for engaging in this strategy is the cost of the options contract itself.

Options Used for Income Generation

Some investors use call options to generate income through a covered call strategy. This strategy involves owning an underlying stock while at the same time writing a call option, or giving someone else the right to buy your stock. The investor collects the option premium and hopes the option expires worthless (below strike price). This strategy generates additional income for the investor but can also limit profit potential if the underlying stock price rises sharply. This is because if the stock rises above the strike price, the option buyer will exercise their right to buy the stock at the lower strike price. This means the option writer doesn’t profit on the stock above the strike price. The options writer’s maximum profit on the option is the premium received.

Options Used for Speculation

Options contracts give buyers the opportunity to obtain significant exposure to a stock for a relatively small price. Used in isolation, they can provide significant gains if a stock rises, but can also lead to a 100% loss of the premium if the call option expires worthless because the underlying stock price fails to move above the strike price. The benefit of buying call options is that risk is always capped at the premium paid for the option.