What are Call Options?
When do you Buy Call Options?
How do You Make Money Trading Call Options?
Call Options Definition:
Call options are a type of security that give the owner the right to buy 100 shares of a stock or an index at a certain price by a certain date. That "certain price" is called the strike price, and that "certain date" is called the expiration date. A call option is defined by the following 4 characteristics:
- There is an underlying stock or index
- There is an expiration date of the call option
- There is a strike price of the call option
- The option is either the right to buy or the right to sell (call and put, respectively)
Long Call Example
A call option is called a "call" because the owner has the right to "call the stock away" from the seller. It is also called an "option" because the owner of the call option has the "right", but not the "obligation", to buy the stock at the strike price. In other words, the owner of the call option (also known as "long a call") does not have to exercise the option and buy the stock--if buying the stock at the strike price is unprofitable, the owner of the call can just let the option expire worthless.
The most attractive characteristic of owning a call option is that your profit is technically unlimited. And your loss is limited to the amount that you paid for the option. Since owning a call option is always cheaper than owning the stock itself, when you KNOW a stock price is about to move up, it is ALWAYS more profitable to own a call option on the stock than it is to own the stock itself! Keep reading and I will explain why.
Call Option Example
Take a look at the screen shot to the right that is from my Etrade account. This shows that Microsoft (MSFT) is at $25.81 and that the April options expire on April 16, 2011 and that the strike prices for the call option and put options range from at least $23 to $28 and are at every dollar in between.
Since call options give the owner the right to buy a stock at a fixed price, owning call options allows you to lock in a maximum purchase price for a stock. It is a maximum purchase price because if the market price is lower than your strike price, then you would buy the stock at the lower market price and not at the higher exercise price of your option. It is called "a call option" because it allows you to "call" the stock away from somebody (ie, buy it).
Call options trade on an exchange, just like stocks do. Like all securities, each call option has a unique ticker symbol and its price is determined by the market. The collection of buyer and sellers of the specific call option at any point in time determine the current prices.
Options have a bid and ask price just like stocks. But because the volume on options is much lower than the volume on stocks, the spread between the bid price and the ask price is much higher than the bid/ask spread on stocks. Whereas the bid/ask spread on stocks is usually just one or two cents, the bid/ask spread on call options and put options can be as high as 20 cents or more.
Look at the screen print of the MSFT options above. You will see that the bid/ask spread ranges from 3 cents on the 23 strike price (bid $2.85 / ask $2.88) to 1 cent on the 26 strike price (bid $0.39 / ask $0.40).
When to Buy a Call Option:
If you think a stock price is going to go up, then there are 3 trades that you can make to profit from a rising stock price:
- you can buy the stock
- you can buy call options on the stock, or
- you can write put options on the stock
Call and Put Option Trading Tip: Before we get too far along in talking about call options and trading call options, you need to understand that a stock price can move in three directions, not just two:
- A stock price can go up
- A stock price can go down, and
- it can stay the same!
Keep these 3 directions in mind as you read on. The rest of this page is devoted to understanding what call options are.
Example of a Call Option:
Suppose YHOO is at $40 and you think YHOO's stock price is going to go up to $50 in the next few weeks. One way to profit from this expectation is to buy 100 shares of YHOO today at $40 and sell it in a few weeks when it goes to $50. This would cost $4,000 today and when you sold the 100 shares of YHOO stock in a few weeks you would receive $5,000 for a $1,000 profit and a 25% return.
That sounds great, but watch how buying a call option on YHOO would have given you a 400% return (instead of the 25% return from buying the stock!
Great Call Option Example: How to Turn $4,000 into $20,000:
Here's how: With call options, you could buy one call option contract for 100 shares of Yahoo! (YHOO) at a strike price of $40 which expires in two months.
For now, let's assume that this call option was price at $2.00 per share, or $200 per contract (each option contract covers 100 shares so when you see the price is $2.00 you need to think $200 per contract). This call option on YHOO now gives you the right, but not the obligation, to buy 100 shares of YHOO at $40 per share anytime between now and the 3rd Friday in the expiration month.
Call Option Payoff Diagram
When YHOO goes to $50, our call option to buy YHOO at a strike price of $40 will be priced at least $10 or $1,000 per contract. Why $10 you ask? Because you have the right to buy the shares at $40 when everyone else in the world has to pay the market price of $50, so that right has to be worth $10! This option is said to be "in-the-money" $10 or it has an "intrinsic value" of $10.
So when trading the YHOO $40 call, we paid $200 for the contract and sold it at $1,000 for a $800 profit on a $200 investment--that's a 400% return.
In the example of buying the 100 shares of YHOO we had $4,000 to spend, so what would have happened if we spent that $4,000 on buying more than one YHOO call options instead of buying the 100 shares of YHOO stock? We could have bought 20 contracts ($4,000/$200=20) and we would have sold them for $20,000 for a $16,000 profit.
Call Options Trading Tip: In the U.S., most equity and index option contracts expire on the 3rd Friday of the month, but this is starting to change as the exchanges are allowing options that expire every week for the most popular stocks and indices.
Call Options Trading Tip: Also, note that in the U.S. most call options are known as American Style options. This means that you can exercise them at any time prior to the expiration date. In contrast, European style call options only allow you to exercise the call option on the expiration date!
Call and Put Option Trading Tip: Finally, note from the graph below that the main advantage that call options have over put options is that the profit potential is unlimited! If the stock goes up to infinity then you make $infinity. This contrasts to a put option in the most that a stock price can go down is to $0. So the most that a put option can ever be in the money is the value of the strike price.
Call Option Payoff Diagram
What happens to the call options if YHOO doesn't go up to $50 and only goes to $45?
If the price of YHOO rises above $40 by the expiration date, to say $45, then your call options are still "in-the-money" by $5 and you can exercise your option and buy 100 shares of YHOO at $40 and immediately sell them at the market price of $45 for a $3 profit per share. Of course, you don't have to sell it immediately-if you want to own the shares of YHOO then you don't have to sell them. Since all option contracts cover 100 shares, your real profit on that one call option contract is actually $300 ($5 x 100 shares - $200 cost). Still not too shabby, eh?
What happens to the call options if YHOO doesn't go up to $50 and just stays arond $40?
Now if YHOO stays basically the same and hovers around $40 for the next few weeks, then the option will be "at-the-money" and will eventually expire worthless. If YHOO stays at $40 then the $40 call option is worthless because no one would pay any money for the option if you could just buy the YHOO stock at $40 in the open market.
In this instance, you would have lost only the $200 that you paid for the one option.
What happens to the call options if YHOO doesn't go up to $50 and falls to $35?
Now on the other hand, if the market price of YHOO is $35, then you have no reason to exercise your call option and buy 100 shares at $40 share for an immediate $5 loss per share. That's where your call option comes in handy since you do not have the obligation to buy these shares at that price - you simply do nothing, and let the option expire worthless. When this happens, your options are considered "out-of-the-money" and you have lost the $200 that you paid for your call option.
Important Tip - Notice that you no matter how far the price of the stock falls, you can never lose more than the cost of your initial investment. That is why the line in the call option payoff diagram above is flat if the closing price is at or below the strike price.
Also note that call options that are set to expire in 1 year or more in the future are called LEAPs and can be a more cost effective way to investing in your favorite stocks.
Always remember that in order for you to buy this YHOO October 40 call option, there has to be someone that is willing to sell you that call option. People buy stocks and call options believing their market price will increase, while sellers believe (just as strongly) that the price will decline. One of you will be right and the other will be wrong. You can be either a buyer or seller of call options. The seller has received a "premium" in the form of the initial option cost the buyer paid ($2 per share or $200 per contract in our example), earning some compensation for selling you the right to "call" the stock away from him if the stock price closes above the strike price. We will return to this topic in a bit.
The second thing you must remember is that a "call option" gives you the right to buy a stock at a certain price by a certain date; and a "put option" gives you the right to sell a stock at a certain price by a certain date. You can remember the difference easily by thinking a "call option" allows you to call the stock away from someone, and a "put option" allows you to put the stock (sell it) to someone.
Start learning about what is a put now or see my Review of the Best Option Brokers
Here are the top 10 option concepts you should understand before making your first real trade: