What you need to know about call options
A call option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a given price (strike price) within a defined timeframe. Because they derive their value from the underlying asset, which can be a stock, bond or other instruments, call options, just like put options, are known as derivatives.
If the call option is not exercised within the expiration date, it no longer carries any value. The expiration date of stock options is the last Friday of the option expiration month.
The price at which the call option is bought or sold when exercised is known as the strike price. As a stock call option holder, you would exercise your right to buy the shares only if the current share price is greater than the strike price. The difference between the current share price and the strike price represents your profit if you were to exercise the option or sell the call option.
In reality, when you purchase a call option, you have to pay a premium to the writer of the option (the seller of the option). Such premium varies based on several factors such as the volatility of the underlying asset, the time remaining to the expiration of the call option, the share price, the option strike price and interest rates. The premium is the overall cost of the option. If you are a call option holder and decide not to exercise it because it is not in-the-money, then the most you would lose the premium that you initially paid for the call option.
Recall that all stock option contracts refer to 100 shares. If you haven’t already done so, read our introductory article on stock options trading.
As mentioned in the introductory paragraph, the buyer of the call option is not obliged to buy the underlying asset. On the other hand, the seller of a call option is obliged to sell the underlying asset at a given price to the option buyer. Because of the risk associated to such obligation, the premium paid by the buyer goes to the call option writer.
When to buy a call option
If you think the share price of the underlying stock will appreciate then you would consider buying a call option.
When to sell a call option
If you think the price of the underlying stock will fall then you would consider selling a call option. Investors adopting a covered call strategy sell call options to generate short term income (from the option premium) while holding the asset long. If the investor does not own shares of the underlying asset but writes calls, this is known as naked calls, or uncovered calls. Such strategy involves a very high level of risk because the investor does not own shares of the underlying stock.