What are Call Options?
Even if you are a novice at trading, you would’ve come across the term, ‘options.’ If you quickly want to escalate your trading skills and experience, knowing about call options is a must.
Seasoned trading players also attest to the benefits of using call options. Call options can appreciate quickly, even with a slight fluctuation of stock prices. It makes them a favourite with many traders looking to make big profits.
This article will help you understand what call options are and how do they work.
What is a Call Option?
A call option is a right, but not an obligation, to purchase any stock at specific price points, at a particular date. Owing to this right, the call option buyer will pay an amount known as premium. The call seller will receive this premium amount from the call buyer.
Unlike stocks, which exist as a perpetuity, the call options cease past their expiration. It can end up being of highly exceptional value or completely worthless.
Here are the components of the call option:
- Expiration: Expiration is when the call option reaches expiry and has been settled
- Strike Price: The strike price is the rate at which you can purchase the underlying stock
- Premium: The price of the call option, for either the buyer or seller
A single call option is a contract, and each stock contract constitutes 100 shares of the underlying asset. The stock exchanges quote the price of options as per-share price. Bear in mind that the price is not the total price for owning the contract.
Let’s help you understand this with the help of an example. An option might have the price of $0.62 on the stock market. Therefore, if you want to purchase a single contract, you have to pay (100 shares x 1 contract x $0.62), or $62.
Call Options Vs. Put Options
A call option is the exact opposite of the put option. A put option enables the right to sell the underlying stock at fixed expiration date and a predetermined rate.
A call option buyer can exercise his right to purchase shares at the strike price before the expiry date. On the other hand, the put option buyer can exercise his right to sell shares of the stock at the strike price.
How Does It Work?
Call options are beneficial when the price of stocks is above the current price at the expiration date. The call option owner can exercise his right to purchase the stock at strike rate.
Alternatively, you can also sell the call option at a reasonable market value to another call option buyer. If you are a call owner, you can generate profits when the premium is less than the difference between the strike price and stock price.
For instance, consider you purchased a call for $0.75 at a strike price of $25, and the stock is $28. Then the option is worth around $3, and you’ve made a profit of $2.25.
Similarly, if the stock price is below the strike price at the specific dates, it is an out-of-the-money situation, and the call is worthless. The call seller will retain any premium that the option generates.
Why Should You Buy a Call Option?
If you are buying a call option, you’re a holder. The most prominent advantage of buying a call option is that it can magnify your gains.
You can enjoy phenomenal gains well above the strike price for a minimal upfront cost until the expiry.
So, if you are buying a call option, expect to gain when the stock prices rise before the expiration date.
We’ll consider another example to explain this situation. Imagine you have a stock of company ABC at $15 per share. You can buy a call on the same stock with a strike price of $15 for $2. One contract will cost you $200.
As for the profit, it’ll depend on the strike price. As the strike price will gradually increase, your profits will increase too.
Why Should You Sell a Call Option?
Call option sellers are writers who sell call options if they feel that the stock will become worthless on expiry. You can make money by selling a call option by pocketing the premium from call option holders.
You can sell a call option in two methods, and they are:
Naked Call Option
You can describe the naked cal option when the seller sells the option even without owning the stock. Naked call options are risky since there is no limit to the end prices of the stocks.
The seller has no risk coverage against losses in these call options as he doesn’t own the underlying stock. When the holder exercises the right, the naked seller must purchase the underlying asset at the current price.
If the stock price exceeds the strike price, then it’ll be a loss for the seller. For this reason, many option sellers demand a high fee for compensating the losses.
Covered Call Option
The covered call option is where the writer of the call option owns the underlying stock for real. Selling off the call options on these underlying assets adds to the income amount. Besides, it’ll offset any potential reductions in the stock prices.
Here, the option seller has protection against the loss. When the buyer of the call option exercises his right, the seller will provide the shares. Moreover, the seller can sell the shares that he had previously purchased at a price well below the strike price.
The seller’s income owning the shares of the stock be dependent on the rise in the strike price. On the brighter side, the seller will be more protected from potential losses.
Though options can be a risky business, traders have to find a way to use them sensibly. If you make proper use of them, they can help you limit risks. Not to mention, the profits that the call options can generate are overwhelming.
Moreover, you can also opt for a home run if you want golden opportunities! That said, practicing and learning will help you make better use of call options.
Now that you know all about call options rush to the playing field.