What is a Call Option

A call option, usually just labeled a "call", is simply a money agreement i.e. a contract, between 2 people, a buyer and the seller . The buyer of the call has the 'right', but is not required, to buy an agreed upon amount of a financial entity, such as a stock, from the seller at a predetermined point in time (called option expiration date) for an agreed upon price (called the strike price). The financial instrument can be a stock, futures contract, gold contract, etc. For this write-up we will simply refer to it as a stock. The burden is on the seller because he/she is required to sell the stock to the buyer at the agreed upon price, if the buyer wants it. The buyer pays a fee (called a premium) for this right.

call optionThe buyer of a call option purchases it in anticipation that the value of the stock will rise in the future. The seller of the option frequently expects that it will not, or is willing to give up a little of his/her profit if the stock price rises, in return for the premium and preserving the opportunity to make a profit. The profit/loss graph of a call option for a buyer is shown to the left.

Call options are the most lucrative for the buyer whenever the stock goes significantly above the strike price. The call buyer believes it's probable the price of the stock will increase above the option's strike price by the exercise date of the option. The buyer's maximum loss is limited to the option premium that he paid. The revenue for the buyer can be quite significant if the stock takes a dramatic price increase. How much profit is determined by exactly how high the stock price rises.

short call optionObviously the call writer does not think the price of the stock is likely to rise above the strike price. The writer sells the call to collect the premium and does not receive any gain if the stock rises above the strike price. The profit/loss graph of a call option for a seller is shown to the left.

 

The buying or selling of a call option does not supply an actual physical or financial asset (ex: stock). Instead it is only the giving to the buyer of the call the right to purchase the stock, in exchange for a cost — the option price or premium.

Exercising an option transaction is different depending on option style. A European call option allows the holder to exercise the option (i.e., to buy) only on the option expiration date. An American call option allows exercise at any time during the life of the option.

A tradeable call option should never be mistaken for Incentive stock options. An incentive stock option, the option to purchase stock in a particular company, is a right given by a business to a particular person (typically executives) to purchase treasury stock. When an incentive stock option is exercised, new shares are issued. These business issued call options are not traded on the open market.  In contrast, when a stock market call option is exercised, the stock or underlying asset is transferred from one owner to another.

Example of a call option on a stock

As noted above. a trader 'buys a call' when he anticipates the price of the stock will exceed the call's 'strike price,' preferably significantly so, before the call expires. The investor pays a nonrefundable premium for the legal right to exercise the call at the strike price, meaning he can purchase the stock at the strike price. Typically, if the price of the stock exceeds the strike price, the buyer exercises the option to actually buy the stock, and then sells the stock and pockets the profit. Of course, the investor can also hold onto the stock, if he feels it will continue to climb still higher.

An trader typically 'writes a call' when he anticipates the price of the stock to stay beneath the call's strike price. The writer (seller) receives the premium up front as his/her income. However, if the call buyer chooses to exercise his option to buy, then the writer has the responsibility to sell the stock at the strike price. In many cases the writer of the call does not actually own the stock, and has to buy it on the open market in order to be able to sell it to the buyer of the call. The seller of the call will lose the difference between his or her purchase price of the stock and the strike price of the call option. This possibility can be huge if the stock skyrockets suddenly in price.

TRADING EXAMPLE:

The existing price of ABC Corp. stock is $45 per share, and trader 'Tom' expects it will go up significantly. Tom purchases a call contract for 100 shares of ABC Corp. from Mary,' who is the call seller. The strike price for the contract is $50 per share, and Tom will pay a premium up front of $5 per share, or $500 total.  If ABC Corp. fails to rise then Tom has lost $500.

ABC Corp. stock ultimately increases to $60 per share before the contract expires. Tom exercises the call option by buying 100 shares of ABC from Mary for a total of $5,000. Tom subsequently sells the stock on the market at market price for a total of $6,000. Tom has paid a $500 contract premium plus a stock cost of $5,000, for a total of $5,500. He has earned back $6,000, yielding a net profit of $500. BUT don't forget he has to pay transactions cost, so his profit will be less than $500.

If, unfortunately, the ABC stock price drops to $40 per share when the contract expires, Tom will not exercise the option (i.e., Tom will not buy a stock at $50 per share from Mary when he can buy it on the open market at $40 per share). Tom loses his premium, a total of $500. Mary, however, retains the premium with no other out-of-pocket expenses, making a profit of $500.

The break-even stock price for Tom is $55 per share, i.e., the $50 per share for the call option price plus the $5 per share premium he paid for the option. If the stock reaches $55 per share when the option expires, Tom can recover his investment by exercising the option and purchasing 100 shares of ABC Corp.. stock from Mary at $50 per share, and then quickly selling those shares at the market price of $55. His total costs are then the $5 per share premium for the call option, plus $50 per share to buy the shares from Mary, for a total of $5,500.  His total earnings are $55 per share sold, or $5,500 for 100 shares, yielding him a net $0. (Be aware that this does not take into account broker fees or any other financial transaction costs.)

When you decide to buy a call, you need to expect the market to move a large amount.  This is simply because before you can begin making money, the stock price must go well beyond the strike price you selected so you can recover the premium you paid!  And then if you exercise the option you must pay the broker costs if you sell the stock.  Most options are either sold before expiration for a profit or allowed to expire worthless.   In the above example, the stock price will have to increase by 33% for Tom to make a small gain!!!

A better way to earn income if the stock does go above the strike price is to simply sell the option before expiration. This is what most traders will do!!!

I do NOT buy call options because it requires you to KNOW with certainty which way the market will move.  From the above example you can see that the stock must move a LARGE amount for you to make any money!!! Thus the probability of consistent success buying calls is VERY low.


 

Iron Condor - Puts and Calls

 

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