What are Call Options?
The call option is a contract between a trader/buyer and a seller of an option, in which the trader/buyer has the right to buy the traded asset at a specific price and within a specific period. However, the trader is not obligated to follow through on the purchase.
In simple terms, the call contract is a “buy” option trade, in which the trader makes money when the price of the asset rises.
All options contracts have a buyer (trader) and seller. The seller, also known as the option writer, is obligated to sell the call contract to the buyer at a strike price and by a specified date (the expiration date). The buyer has the right to cash in on the option or not to do anything once the option expires.
For this example, let us assume that the trader wants to purchase the call contract on stock XY, currently at $100. The trader buys a standard option contract worth $2 per share. A standard options contract is equivalent to a holding of 100 shares, so this contract is worth $200.
In simple terms, the call option trade will be represented like this:
Long 1 XY 100 Call ($200)
If the call option expires with stock XY priced at $105, then the trader can decide to exercise his option by selling the shares at the new price, which will give a profit of $5 per share on the options contract, which is a total of $500. The trade is said to be in-the-money and the trader’s net profit will be the proceeds the trader made from exercising the option MINUS the cost of the options contract.
Net profit = $500 – $200 = $300.
If the call option expires with stock XY priced at anything below $102 (e.g. $101), the options contract is worth just $1 per share, which is a total of $100. Having spent $200 acquiring the call option contract, the trader will lose money, but not all his investment.
Net loss = $100 – $200 = – $100.
If the call option expires with stock XY priced at or below $100, the option contract will be worthless and the trade is out-of-the-money. In this scenario, the trader will lose his entire investment. This investment is the premium paid on the trade, which is $200.
The call option can be used as a speculative vehicle of investment, but also as a hedge trade. As a hedge trade strategy, the call option is used to hold an opposite position to that held in a stock so that if there is an adverse movement in the price of a stock, the call option can protect against those losses.
As in other options trade types, the trader must analyse the traded asset properly in order to get his trade right. Of course, attention should also be paid to risk management. If the trader is able to get this right, then he will smile to the bank on payday.