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What Is a Call Option?

Investing, Investing Strategy
Call options

Call options. They appear in movies and TV shows. Employees sometimes receive call options when they join a company. They’re exciting. When a stock goes up, its call options go up significantly. When people talk about options, they usually mean calls, even though they’re one of the two plain vanilla flavors in options trading, along with puts.

Call options

The basic question in an options trade is this: What will a stock be worth at some future date? There are only two answers: more or less.

Buying a call option is a bet on “more.” Selling a call option is a bet on “less.”

This article provides examples of the upsides and downsides of buying and selling calls, and how that compares to owning a stock directly.

A call option is a contract that gives the owner a right, but not the obligation, to call in or buy a specific stock at a predetermined price (known as the “strike price”) within a certain time period (or “expiration”). For that privilege, the call buyer pays a “premium” per share to the call seller.

Each contract represents 100 shares of the “underlying” stock, or the stock on which the option is based. Investors don’t have to own the underlying stock to buy or sell a call.

At expiration, if the stock price is lower than the strike price, the call is worthless.

If the stock price is higher than the strike, the call is worth money. In this situation, the value of the call equals the stock price minus the strike price times 100, because each contract represents 100 shares.

Buying a call option

Buying a call option 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 a call provides a greater potential profit than owning the stock directly.

If the stock rises above the strike price before expiration, the option is considered to be “in the money.” Then 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 the profit.

If the stock stays at the strike price or below at expiration, the call is “out of the money.” 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 is trading for $50 a share. Calls with a strike price of $50 are available for $5 per contract and expire in six months. In total, one call costs $500 (1 call x $5 x 100 shares).

The graph below shows the buyer’s profit on the call at expiration with the stock at various prices.

Because one contract represents 100 shares, for every $1 increase in the stock above the strike price, the total value of the option increases by $100.

The breakeven point — above which the option starts to earn money — is $55 per share. That’s the strike price plus the cost of the call. If the stock closes at expiration between $50 and $55, the buyer would recoup some of the initial investment, but the option does not show a net profit. If the stock finishes below the strike price at expiration, the option becomes worthless. Then option value flatlines, capping the investor’s maximum loss at the initial outlay of $500.

Selling a call option

Call sellers have an obligation to sell the underlying stock at the strike price until expiration. 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 closes above the strike price at expiration, 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 at expiration, 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 $5 per contract and expire in six months. In total, one call sells for $500 (1 call x $5 x 100 shares).

The graph below shows the seller’s profit on the call at expiration 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 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 closes at expiration between $50 and $55, the seller retains some but not all of the premium. If the stock finishes below the strike price at expiration, the option value flatlines, capping the investor’s maximum gain at the entire premium, or $500.

» Want to get started? Compare the best brokers for options trading

Calls 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 expiring in six months cost $5 per contract. The investor has $500 in cash, which would allow either the purchase of 10 shares of the $50 stock or one call contract. Each options contract represents 100 shares, so 1 contract x $5 x 100 = $500.

Here’s how the payoff profile would look at expiration for stockholders, call buyers and call sellers.

Stock price at expirationPrice movementStockholder's profit/lossCall buyer's profit/lossCall seller's profit/loss
$70+40%$200$1,500-$1,500
$65+30%$150$1,000-$1,000
$60+20%$100$500-$500
$55+10%$500$0
$500%$0-$500$500
$45-10%-$50-$500$500
$40-20%-$100-$500$500
$35-30%-$150-$500$500
$30-40%-$200-$500$500
Assumes no transaction fees

The attraction to buy calls is obvious. If the stock moves up 40% and earns $200, the options magnify that gain to $1,500. If the stock price rises 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 well 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 can be lost, however, if the stock doesn’t rise above the strike price by expiration. A call buyer’s loss is capped at the initial investment, like in the case of stockholders, who can lose no more money than they invested. In this example, the call buyer never loses more than $500 no matter how low the stock falls.

Conversely, while owning the stock directly offers less profitability, the investor can wait indefinitely for the stock to climb. 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.

Finally, call sellers have unlimited liability through the life of the call contract. At most, the call sellers can receive the 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.

Call selling can be dicey, but there is a popular and relatively safe way to do it via covered calls.

» MORE: How to buy stocks

More call option strategies

Call options are popular because they give investors more ways to invest. The biggest lure is that they magnify the effects of stock movements, as the table above indicates. But options have many other uses for sophisticated investors. They also allow investors to:

Limit risk-taking, while generating a capital gain. Options often are seen as risky, but they can also be used to limit risk. 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 it’s a reasonable approach if done in moderation, such as through a safe trading strategy like covered calls. Even on low-volatility, high-quality stocks, investors could see annualized returns in the low teens. It’s an attractive prospect, especially in a flat or slightly down market, where the stock is not likely to be called.

Realize more attractive sell prices for their stocks. Some investors use call options to achieve better sell 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.

James F. Royal, Ph.D., is a staff writer at NerdWallet, a personal finance website. Email: jroyal@nerdwallet.com. Twitter: @JimRoyalPhD.