A call option is an option contract that allows the buyer of the option the right, but not the obligation to buy a stock, or an asset within the stock market at a specific price within a specified time, or within an expiration period of time.
In contrast, a put option allows the buyer of the put, the right but not the obligation to sell their stock at a specific price on or before the expiration period. This decision is affected by the strike price of the underlying on or before the expiration.
How do Call Options Work
As we understand what a call option is, we must now understand how they work. As an option buyer, you have the right to buy the asset or stock at the agreed price before the expiration. This is called exercising the option.
The key take away or thing to remember is that 1 stock option contract equals 100 shares.
Why Buy Call Options
So the reason we would want to buy call options instead of shares is to be able to possibly get into a position without spending as much to do so.
For example: If you are looking to buy Amazon (#AMZN) but not willing to spend the full amount of the 100 shares, you could pay a fraction of the cost, for the call option.
A single share of Amazon is around 1776, at the time of this post. So you would have to spend $1,776 in order to own just 1 share of Amazon.
However, for this example, if the call option is priced 65.00 (65.00 X 100) we could move into the position of the contract for $6,500. As you can see this is a lot cheaper than paying $177,600 for 100 shares.
The takeaway is that we only would have so many days for it to move in our favor. This is called the expiration.
If the stock price moved in your favor and you chose to exercise the option, then the stock would get assigned to you at the agreed price of the option contract, minus the cost of the purchase of that option. You would then own 100 shares and be able to sell them right away for a profit, depending on the price of the shares now.
The alternative, is not exercising, and just selling the option contract for more than you purchased it, BEFORE expiration. This is only if the stock price has moved up.
The price of options are determined by a few things like the volatility, time left before expiration, the movement of the stock price and more.
Another Example of Buying Call Options: Think of buying real estate. Here we will treat our stocks like real estate.
You are wanting to buy a home from a home developer who builds and then sells homes. The house down the road is currently being built and you want to go ahead an invest before it is finished.
The developer is selling a contract to purchase the house for $20,000. The home is currently appraised for $200,000. You believe that by the time the developer is finished with building the house, the area and the house will be worth more.
Therefore, you go and purchase the contract for the $20,000 for the right to buy the home upon completion for the remaining amount, $180,000. ($200,000 – $20,000)
Scenario 1: The house is complete and the market did go up. The house is now appraised for $400,000. The developer wrote you the contract and has to sell the house to you for the $200,000. You already paid $20,000, so that means you owe the remaining amount of $180,000 and get to take ownership of the house.
You get to either sell the house at the now appraised house at $400,000 and of course profit $200,000 or keep the house, and rent it out. This relate to selling covered calls, which is down below in why sell call options.
Scenario 2: The house is complete and the market crashed. The house value is now less than the original $200,000 and is now worth $100,000. You get to walk away as the contract was wrote for $200,000 so therefor you wouldn’t want to take anymore of a loss other than the $20,000 that you purchased the contract for.
Conclusion to Buying Call Options
As you can see the power of buying options and the possible returns that they can bring in, and why the are appealing to the advanced investors who understand stock options.
Why Sell Call Options
The reason that we would sell call options is to be able to sell premium or write them for a profit. When selling, you can sell naked call options (not owning any shares to cover) or selling covered calls (owning shares to cover). Depending on whether or not you’re covered or naked, determines risk to reward.
As mentioned above with the real estate scenario, you can be the developer or person writing options if you are covered, or naked.
If you for example, you own 100 shares of one particular company, you can sell 1 covered call against it, IF it is optionable (having options).
Example: If you own 100 shares of Under Amour, and you had bought the shares at $32, you could write a covered call option for $35. You would take in a premium and sell your shares at 35 for a profit if the stock price would go up to 35 or more by an expiration period. (Premium + Difference = Profit)
If the stock was to drop in price, you would still profit from the covered call that you sold or wrote. You would then keep your shares, and adjust your covered call price the next time if you wanted, and do this over and over again to treat your stocks like real estate.
Writing a naked call, or selling naked options, is doing the same thing as a covered call but without having any shares to cover. The risk here is the amount you would have to come up with if the price was to go up to the strike price of the option you had sold premium toward.
Example: If you sold 1 naked call on a 35 strike price call and the price at expiration was 35 or more, then most likely the option buyer on the other side would exercise the option to take possession of the shares. Your broker would require you to have the cost amount to cover the loss on your side. That amount would be $3,500. Remember 1 option contract is equal to 100 shares.
So now that we know what call options are, why sell call options, and why buy options, hopefully you begin to invest wisely and become more profitable with your stock options strategies. The goal is to maximize returns in the most successful and easiest ways, while minimizing risks.
After reading this, I hope you understand when to buy a call option and when to sell a call option. However, the exact understanding of those two strategies, comes with other areas to learn like implied volatility, historical volatility, IV Rank, and the option Greeks.
Please leave a comment down below if this has helped you better understand what is call options and any questions that you may have!
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