Call Options: What They Are and How They Work
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When people talk about options or options trading, they're usually referring to strategies that involve buying and selling two types of options, calls and puts.
This article provides an overview of why investors buy and sell call options on a stock, and how doing so compares to owning the stock directly.
The basic question in an options trade is: What will a stock be worth at some future date? Buying a call option is a bet on “more.” Selling a call option is a bet on “same or less.”
What is a call option?
Options are a type of financial instrument known as a derivative because their value is derived from another security, or underlying asset. Here we discuss stock options, where the underlying asset is a stock.
A call option is a contract that gives the owner the option, but not the requirement, to buy a specific underlying stock at a predetermined price (known as the “strike price”) within a certain time period (or “expiration”).
For this option to buy the stock, the call buyer pays a “premium” per share to the call seller.
Each contract represents 100 shares of the underlying stock. Investors don’t have to own the underlying stock to buy or sell a call.
If you think the market price of the underlying stock will rise, you can consider buying a call option compared to buying the stock outright. If you think the market price of the underlying stock will stay flat, trade sideways, or go down, you can consider selling or “writing” a call option.
For a call buyer, if the market price of the underlying stock price moves in your favor, you can choose to “exercise” the call option or buy the underlying stock at the strike price. American options allow the holder to exercise the option at any point up to the expiration date. European options can only be exercised on the date of expiration.
Buying and selling call options can also be used as part of more complex option strategies.
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Buying a call option
Buying calls, or having a long call position, feels a lot like wagering. It allows traders to pay a relatively small amount of money upfront to enjoy, for a limited time, the upside on a larger number of shares than they’d be able to buy with the same cash. Call buyers generally expect the underlying stock to rise significantly, and buying a call option can provide greater potential profit than owning the stock outright.
If the stock's market price rises above the strike price, the option is considered to be “in the money.” An in the money call option has “intrinsic value” because the market price of the stock is greater than the strike price. The buyer has two choices: First, the buyer could call the stock from the call seller, exercising the option and paying the strike price. The buyer takes ownership of the stock and can continue to hold it or sell it in the market and realize the gain. Second, the buyer could sell the option before expiration and take profits.
When the stock trades at the strike price, the call option is “at the money.”
If the stock trades below the strike price, the call is “out of the money” and the option expires worthless. Then the call seller keeps the premium paid for the call while the buyer loses the entire investment.
Let’s look at an example. XYZ stock is trading for $50 a share. Calls with a strike price of $50 are available for a $5 premium and expire in six months. In total, one call contract costs $500 ($5 premium x 100 shares).
The graph below shows the buyer’s profit or payoff on the call with the stock at various prices.
Because one contract represents 100 shares, for every $1 increase in the stock price above the strike price, the total value of the option increases by $100.
The breakeven point — above which the option starts to earn money, have intrinsic value or be in the money — is $55 per share. That’s the strike price of $50 plus the $5 cost of the call. When the stock trades between $50 and $55, the buyer would recoup some of the initial investment, but the option does not show a net profit.
When the option is in the money or above the breakeven point, the option value or upside is unlimited because the stock price could continue to climb.
If the stock trades below the strike price, the option is out of the money and becomes worthless. Then the option value flatlines, capping the investor’s maximum loss at the initial outlay of $500.
Buying a call option vs. owning the stock
Buying call options can be attractive if an investor thinks a stock is poised to rise. It’s one of two main ways to wager on a stock’s increase. The other way is by owning the stock directly. Buying calls can be more profitable than owning stock outright.
Let’s look at an example to compare the outcomes for investors of the two call strategies with owning the stock directly.
XYZ stock trades at $50 per share. Call options with a $50 strike price are available for a $5 premium and expire in six months. Each options contract represents 100 shares, so 1 call contract costs $500. The investor has $500 in cash, which would allow either the purchase of one call contract or 10 shares of the $50 stock.
Here’s how the payoff profile would look at expiration for stockholders, call buyers and call sellers.
Stock price at expiration
Call buyer's profit/loss
Call seller's profit/loss
Assumes no transaction fees
The attraction to buy calls the more the stock price rises is obvious. If the stock moves up 40% to $70 per share, a stockholder would earn $200 ($70 market price - $50 purchase price = $20 gain per share x 10 shares = $200 in total profit). However, owning the call option magnifies that gain to $1,500 ($70 market price - $50 strike price = $20 gain per share. $20 - $5 cost of the contract = $15 gain per share x 100 shares = $1,500 in profit).
If the stock price moves up significantly, buying a call option offers much better profits than owning the stock. To realize a net profit on the option, the stock has to move above the strike price, by enough to offset the premium paid to the call seller. In the above example, the call breaks even at $55 per share.
The entire investment is lost for the option holder if the stock doesn’t rise above the strike price. However, a call buyer’s loss is capped at the initial investment. In this example, the call buyer never loses more than $500 no matter how low the stock falls.
For the stockholder, if the stock price is flat or goes down, the loss is less than that of the option holder. Owning the stock directly also gives the investor the opportunity to wait indefinitely for the stock to change direction. That’s a significant benefit over options, whose life expires on a specific date in the future. With options, not only do you have to predict the stock’s direction, but you have to get the timing right, too.
» MORE: How to buy stocks
Selling a call option
Call sellers (writers) have an obligation to sell the underlying stock at the strike price and have a “short call position.” The call seller must have one of these three things: the stock, enough cash to buy the stock, or the margin capacity to deliver the stock to the call buyer. Call sellers generally expect the price of the underlying stock to remain flat or move lower.
If the stock trades above the strike price, the option is considered to be in the money and will be exercised. The call seller will have to deliver the stock at the strike, receiving cash for the sale.
If the stock stays at the strike price or dips below it, the call option usually will not be exercised, and the call seller keeps the entire premium. But on rare occasions, the call buyer still might decide to exercise the option, so the stock would have to be delivered. This situation benefits the call seller, though, since the stock would be cheaper than the strike price being paid for it.
Let’s look at an example. XYZ is trading for $50 a share. Calls with a strike price of $50 can be sold for a $5 premium and expire in six months. In total, one call contract sells for $500 ($5 premium x 100 shares).
The graph below shows the seller’s payoff on the call with the stock at various prices.
Since each contract represents 100 shares, for every $1 increase in the stock above the strike price, the option’s cost to the seller increases by $100. The breakeven point of the call is $55 per share, or the strike price plus the cost of the call. Above that point, the call seller begins to lose money overall, and the potential losses are uncapped. If the stock trades between $50 and $55, the seller retains some but not all of the premium. If the stock trades below the strike price, the option value flatlines, capping the seller’s maximum gain at $500.
At most, call sellers can receive the contract premium — $500 — but they have to be able to deliver the stock at the strike price if the stock is called by the buyer. Potential losses theoretically are infinite if the stock price continued to rise, so call sellers could lose more money than they received from their initial position.
» Want to get started? Compare the best brokers for options trading
Selling calls can be dicey, but there is a popular and relatively safe way to do it via covered calls, which limits the unlimited liability of a “naked” call option discussed above, where the seller sells the call without also owning the underlying stock.
Why call options can make sense
Call options are popular because they can allow investors to achieve different means. One lure for investors wanting to speculate is that they can magnify the effects of stock movements, as the table above indicates. But options have many other uses, such as:
Limit risk-taking, while generating a capital gain. Options often are seen as risky, but they can also be used to limit risk or hedge a position. For example, an investor looking to profit from the rise of XYZ stock could buy just one call contract and limit the total downside to $500, whereas for a similar gain a stockholder’s much larger investment would be wholly at risk. Both strategies have a similar payoff, but the call limits potential losses.
Generate income from the premium. Investors can sell call options to generate income, and this can be a reasonable approach when done in moderation, such as through a safe trading strategy like covered calls. Especially in a flat or slightly down market, where the stock is not likely to be called, it can be an attractive prospect to generate incremental returns.
Realize more attractive selling prices for their stocks. Some investors use call options to achieve better selling prices on their stocks. They can sell calls on a stock they’d like to divest that is too cheap at the current price. If the price rises above the call’s strike, they can sell the stock and take the premium as a bonus on their sale. If the stock remains below the strike, they can keep the premium and try the strategy again.
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