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What is a call option? Definition, explanation and strategies

A call option is a derivative contract that grants its buyer the right to buy stock at a predetermined price.

What are call options and how do they work?

A call option is an options contract that grants its buyer the right (but not the obligation) to buy a specific quantity (usually 100 shares) of an asset (like a stock) at a specific price at the later than the expiry date of the contract. .

In return for this right, the buyer of the option pays a premium to the seller of the option. A call option is considered a derivative security because its value is derived from the value of an underlying asset (eg, 100 shares of a particular stock). Investing in a call is like betting that the price of a stock will rise before the call contract expires. In other words, calls are usually bullish investments.

Call Options vs. Put Options

Call options are the opposite of put options. While calls give their owners the right to buy something at a specific strike price, put options give their owners the right to sell something at a specific strike price.

A call investor bets on the rise in value of a security (which would allow him to buy shares at a price lower than its value or to sell the contract at a price higher than what he paid), while that an investor is betting on the value of a security going down (which would allow them to sell shares at a price higher than their value or to sell the contract at a price higher than what they paid).

How to make money with a call option?

Investors can realize gains on call options in two ways: resell or exercise.

Each option has a premium (current market value) for which it can be bought and sold, and this premium changes over time depending on factors such as the intrinsic value of the contract (the difference between the strike price of the contract and the market price of the underlying asset), the time remaining until expiry and the volatility of the underlying asset.

The more intrinsic value an option has, the more volatile the underlying security, and the longer the expiration, the more expensive an option is.

To make a profit, an options trader might buy a call option for a security that he thinks will go up in value. If this happens, the option’s premium will increase and the contract holder can sell the option back for their new, higher premium, pocketing the difference between the price they sold it for and the price they sold it for. bought.

Alternatively, an investor could buy a call option contract with a strike price equal to the market price of an underlying security in the expectation that the security will gain value before the contract expires. If the price of the underlying security rises, the option holder can exercise the option and buy shares at the strike price, which is lower than the new market price of the underlying asset. Their profit here is the market price of the stock minus the strike price of the call option multiplied by 100 shares, minus the premium they paid for the contract.

It is important to remember here that the premium an investor pays for a contract is part of its cost basis and should be considered when deciding when to sell or exercise an option for profit. Options investors only make a profit if their earnings exceed the premium they paid for the options contract in question.

Why do investors buy call options?

Many investors find call options attractive because they do not require a large amount of initial capital. In effect, calls allow a trader to profit from the upward movement of a stock’s price (in increments of 100 shares) without actually buying the stock itself.

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TheStreet Dictionary Terms

Also, risk is limited, because the most an options buyer stands to lose is the premium they paid for the contract itself, not the full value of the underlying stock.

Essentially, call options allow bullish traders to bet on price appreciation without having to buy actual stocks, which requires more capital and involves more risk.

How do I know if a call option is in-the-money (ITM) or out-of-the-money (OTM)?

Options that have intrinsic value are considered “in-the-money”, while options that do not are considered “out-of-the-money”. A call option is in-the-money and has intrinsic value if its strike price is lower than the market price of the underlying asset (also called the spot price).

For example, a call option with a strike price of $50 and a spot price of $60 would be in the money $10, because if exercised immediately, the shares could be purchased at a discount of 10 $. In other words, this particular purchase contract would have an intrinsic value of $1,000 because it grants its owner the right to buy 100 shares for $10 less than they are worth.

Intrinsic value is always included in an option’s premium, so there would be no point in buying a call in the money just to exercise it immediately, because its premium would embed its intrinsic value, so no gain would be realized. If an investor purchased the notional call option discussed above, they would do so with the expectation that the price of the underlying asset would continue to rise, causing the intrinsic value of the option would exceed the premium he had paid before exercising or reselling the contract.

If the strike price of a call option was higher than its spot price, it would be considered out of the money because it would lack intrinsic value. In other words, there would be no point in exercising an OTM call because if you did, you would be buying shares at a higher price than they cost on the open market.

How to trade call options

Options such as calls can be traded through the most popular trading platforms such as Charles Schwabb, Robinhood, WeBull and Fidelity. Generally, however, investors should seek approval from their brokerage before beginning to trade options. Options can also be traded directly, and not through a broker, in the over-the-counter (OTC) market.

2 Common Call Swapping Strategies

There are many ways to trade calls, but the following three strategies are some of the most common.

1. Long call

A long call is the simplest call trading strategy. If an investor is bullish on a stock (ie, they believe its value will rise), they can buy a call option on it. If they choose an option whose strike price is equal to or greater than the market price of the underlying asset (i.e. out of the money), there will be no intrinsic value included in the contract premium.

If the stock in question goes up in value before the contract expires, the option can acquire intrinsic value by moving in the money, and the investor can then either resell it at a profit or exercise it in order to buy shares of the underlying stock for less than they are worth.

An investor can time a long call so that its expiration occurs some time after an event that they believe will impact the price of the underlying stock, such as an earnings report or the close of a trade. acquisition. If their prediction is wrong and the news sends the stock plummeting, the most they stand to lose is the premium they paid for the contract. If, on the other hand, their prediction is correct, their profit simply depends on the rise in the stock price.

2. Covered call

Covered call options are typically written by investors who are long in a stock (i.e. they own it and don’t plan to sell it in the near future) but don’t believe that its price will increase significantly in the short term. An investor like this would write a call option for 100 shares he owns with a strike price similar to the current market price. This means that if the stock price drops, the options would expire worthless and the investor who wrote the call could pocket the premium.

If, however, the value of the stock in question increased significantly before the expiration of the contract, the buyer of the call option would have the right to buy the stock from the seller below market value. Fortunately, the seller wouldn’t have to buy those shares at their new higher price and sell them back at a loss since he already owned them.

This would not be an ideal situation for the option writer, as he would have missed out on the gains he would have made had he simply continued to hold his original long position in the underlying stock.