What is a the Definition of a call option?
A call option is a contract that gives the holder the right to
buy the underlying stock at a specific price. If a person is
bullish on the stock (expects the stock to rise) in the near
term, that person could buy a call option.
Call option contracts have risk to the buyer or holder. If the
option is not profitable, the investor could lose all of the
money that was paid for the contract. The money is spent is the
premium. The premium is the market price for the option, which
will change with the market of the underlying stock. If the
market rises after a call option is purchased, the premium will
rise and the investor will be profitable. The customer could
either trade the option back to the market for a profit or they
can exercise the option (purchase the stock at the price on the
option and then sell it at some point at the going market
Trading Call Options
Most option investors trade them for premium gain or loss vs.
exercising the options. If an option is bought for $300 and the
market on the stock rises, the investor could sell the call
option back to the market for a profit at the increased premium.
Options carry a unique risk. Unlike owning stock, options expire
after a certain period. Standardized options have monthly
expirations with a maximum duration of 9 months. A person owning
a call option that has an expiration 2 months from purchase
month, only has that amount of time to close the position -
hopefully at a profit. If the position is left open until the
expiration date, the call option will expire worthless. The
maximum loss for an owner of a call option is the premium paid.
Since the profit on a call option is based on the increase of
the underlying stock, the profit potential is unlimited. The
holder has the right to buy the stock at a set price (strike
price), so if the market on the stock is 10 points higher than
your strike price when you exercise the contract, you can make
that 10 points - minus your premium paid. If the market is 30
points higher, you can make 30 points, less you strike price and
so on. There is no ceiling to profit.
Hedging and Protection
Call options can be used as protection for existing positions.
If you have sold a stock short, a long call option can be used
to protect this position. The short sale must be covered,
hopefully at a lower price than the short sale itself - that is
how you make money on short sales. The loss potential when you
sell stock short is unlimited (if the position is not
protected). The stock could rise to an unlimited amount, and you
may be forced to buy back the stock at an inflated price, thus
resulting in a loss. A call option allows the investor to buy
back the stock at a fixed strike price. Having a call option
against your short protects you. The negative aspect to this is
that the premium paid for the option will hurt your overall
profit on the short sale.
Short Call Options
Some investors "Sell Calls" or "Short Calls". The purpose is
here is for the option itself to expire. People who short call
options collect the premium (vs. the buyers who pay the
premium), so if the option expires - the seller will gain that
money. The risk with these are enormous, if the option is not
covered (you own the underlying stock). If the option is left
uncovered or "naked", the seller can sustain and unlimited loss.
The seller or "writer" of call options is obligated to deliver
the stock to the call holder at the strike price, if the option
is exercised. If the write does not own the stock to perform
this obligation, he must go and get it at the market. If the
market is significantly higher than the strike price, he can
lose that difference.
The more conservative way to engage in call shorting, is to do
them with existing long stock positions. If a person owns shares
at a price, he or she can short a call option the same stock.
Doing this allows the person to make the premium, thus lowering
his cost. It also covers the option itself, so if the option is
exercised - the investor can deliver his own stock and not have
to buy a new 100 shares from the market.
Only seasoned investors should engage in options trading. Talk
to your broker or advisor to see if they are right for you.
"Baby Steps" are the key in the beginning, but once you know
your way around, you can put yourself in very profitable