Call Options

Buying a call option ("a call") gives you the right, but not the obligation, to purchase an underlying security at a predetermined price for a certain time period. Call options are available in various strikes and expiration dates. Expiration dates very from as short as one month to as long as a year or more. You are betting that the underlying security will rise within the time that your option is valid, as a call options buyer. The amount you paid for the option, is the maximum risk you take by buying a call option; in other words, you cannot lose more than the premium you paid for the call. Depending on the price increase of the underlying security is the extent of you potential profit. The long call becomes more valuable, as it goes up, because you have paid for the right to buy the underlying security at a given strike price. That is the reason why traders buy call options in a rising or bull market.

Here is a simple example:

Let's assume that a particular stock currently trades at $40. You can buy a call with an expiration date three months into the future and a strike price of $44. You paid $1 per contract for the right, but not the obligation, to buy 100 shares of the underlying stock for $44.

Now , what if the stock goes up to $50 within the next three months, (i.e., before the option is due to expire). By demanding from the call seller (the option "writer") that he or she sells the stock to you for $44, because now you can exercise your call option. Because you can sell the stock immediately at the current market price of $50, you have made a $6 (600%) profit, minus, of course, the cost of the option purchase.

If we assume the stock has declined to $35 by the time the option expires, on the other hand, it would not make sense to exercise the call and buy the stock for $44. You would let your option expire worthless, in this situation, and take a loss of $1 per contract. It is the seller of the call who will realize a profit of ($1 per contract) in this case.

More about call options

A call option ("calls") is a financial contract between two parties, the calls buyer and the calls seller. The buyer of the call option has the right to buy the underlying assets (stock) from the seller of the option for a certain price (the strike price) and before or at a certain time (the expiration date).

The call options buyer expects the price of the underlying stock to rise in the future but before the options expiration. On the other hand call options seller expects the underlying stock to drop in price.

The call buyer profits when the underlying stock price moves up and looses when the stock drops in price. The maximum the options buyer can lose is the premium paid for options - 100% of the invested funds. The maximum potential profit the options buyer may achieve is theoretically unlimited.

The call seller profits when the underlying stock price declines and the maximum profit could be achieved when sold calls expire worthless - 100% of the premium received for calls. If the underlying stock price moves up the call seller experiences losses and the maximum loss is theoretically unlimited.

The call options are considered in-the money if the current stock price is above the strike price and the call options are considered out-of-the-money if the current stock price is below the strike price. At the expiration the in-the-money options are profitable and out-of-the-money options are worthless.

Call options buyer:

• expects that the price of the stock may go up;
• pays a premium that cannot be received back;
• has the right to exercise the call option at the strike price before or at the expiration date;
• has the right to sell the bought calls.

Chart 1. Buying a call option - the payoffs and profits as seen by the buyer. A higher stock price means a higher profit.

Call options seller:

• receives the premium;
• expects that the price of the stock may go down;
• if the sold call options are exercised, then the writer has to sell the stock at the strike price;
• if the sold call options are not exercised at the expiration, then the writer pockets the received premium as 100% profit;
• can buy the same strike and expiration calls back and close (cover) the position.

Chart 2. Selling a call option - the payoffs and profits as seen by the buyer. A higher stock price means a higher losses.

A simple example of call options on stock:

• 'Trader A' purchases a QQQ Call contract to buy 100 shares of QQQ from 'Trader B' at $40 per share (strike price).
• The current QQQ price is $41 per share.
• 'Trader A' pays a premium of $2 per share - total premium for one QQQ call options contract is $200
• If the QQQ price goes to $45 per share at expiration, then 'Trader A' can exercise the call by buying 100 QQQ shares for $4,000 from the Trader B and sell them at $4,500 in the stock market. In this case 'Trader A' pockets profit of $300 ($500 minus $200 of paid premium), excluding commissions.
• If, the QQQ price drops to $39 per share at expiration date, then 'Trader A' would not exercise the option. (It makes no sense to buy QQQ stock at $40 and when it could be bought at $39 in the stock market). In this case the QQQ calls expire worthless and 'Trader A' losses 100% of the premium paid for calls.

Majority of the options traders do not wait for expiration but rather sell previously bought calls and profit on the difference between the premium paid when calls were bought and premium received when calls were sold. By following the example above:

• 'Trader A' purchases a QQQ Call contract to buy 100 shares of QQ from 'Trader B' at $40 per share (strike price).
• The current QQQ price is $41 per share.
• 'Trader A' pays a premium of $2 per share - total premium for one QQQ call options contract is $200
• If the QQQ price goes up and the bought QQQ call options price goes to $5 per share 'Trader A' can sell previously bout calls and pocked $300 ($500 - $200) profit. In this case "Trader A' pays less commissions than in the first example (he does not exercise options and he does not have to buy and sell QQQ stocks).
• If, the QQQ price of drops to $39 per share the bought QQQ call options price drops to $1 per share 'Trader A' can sell previously bout calls and fix loss of $100 ($200 - $100). In this case "Trader A' does not wait an expiration and fix 50% losses.