History
Options trading can be traced back to ancient Greece, when Thales of Miletus is said to have purchased the right to use all of the olive presses in the region prior to the harvest season. This enabled him to control the price of olive oil and profit from it.
The Chicago Board Options Exchange launched modern options trading in the early 1970s (CBOE). Call options were one of the first options traded on the exchange.
Definition
A call option is a contract entered into by two people: the buyer (also known as the holder) and the seller (also known as the writer). The buyer of a call option pays the seller a premium in exchange for the right to purchase the underlying asset at a predetermined price (the strike price) within a specified time frame (the expiration date).
Put vs Call
| Call | Put | |
|---|---|---|
| Definition | A contract that gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price within a specified time frame. | A contract that gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price within a specified time frame. |
| Profit Potential | Unlimited | Limited to the strike price minus the premium paid |
| Loss Potential | Limited to the premium paid | Unlimited |
| Buyer’s Benefit | Allows the holder to benefit from an increase in the value of the underlying asset | Protects against a decline in the value of the underlying asset |
| Seller’s Benefit | Collects a premium from the buyer | Collects a premium from the buyer |
| Breakeven Point | Strike price plus premium paid | Strike price minus premium paid |
| Use Case | Bullish market outlook | Bearish market outlook |
How it works
1. Paying a premium to seller: The buyer of a call option pays a premium to the option’s seller. The premium is the amount paid by the buyer for the right to purchase the underlying asset at the strike price.
2. Call option strike price: A strike price and an expiration date are associated with the call option. The strike price is the cost of purchasing the underlying asset for the buyer. The option’s expiration date is the date on which it expires.
3. Purchasing underlying asset at strike price: If the underlying asset’s price rises above the strike price before the expiration date, the buyer has the option to exercise it and purchase the underlying asset at the strike price.
For instance, if the strike price is $50 and the underlying asset’s price rises to $60, the buyer can exercise the option and purchase the asset at $50.
4. Buyer can decide to not exercise option: If the underlying asset’s price does not rise above the strike price before the expiration date, the buyer may elect not to exercise the option, and it will expire worthless.
5. Sell at underlying strike price: If the buyer exercises the option, the seller is obligated to sell the underlying asset at the strike price.
Example
Assume you are a fan of the Luis1k stock, which is currently trading at $90 per share. You believe the stock price will rise in the coming month, but you don’t want to invest a large sum of money right away. Instead, you decide to purchase a call option on the Luis1k stock with a $100 strike price and a one-month expiration date.
Step 1: You pay a premium to the option seller. Assume the premium is $5 per share, so you pay $500 for the option (100 shares x $5 premium).
Step 2: The call option has a strike price of $100 and a one-month expiration date.
Step 3: If the underlying asset’s price (in this case, Luis1k’s stock price) increases above the strike price before the expiration date, you can exercise the option and buy the underlying asset at the strike price.
For example, if the price of Luis1k stock goes to $120 per share, you can exercise the option and purchase 100 shares of Luis1k stock for $100, regardless of how high the stock price rises.
Step 4: If the underlying asset’s price does not rise over the strike price before the expiration date, you may elect not to exercise the option, in which case it will expire worthless. In this example, if the price of Luis1k stock does not rise above $100 per share by the expiration date, you will forfeit the $500 premium paid.
Step 5: If the buyer exercises the option, the seller is compelled to sell the underlying asset at the strike price. In this case, if you exercise the option and purchase 100 shares of Luis1k stock for $100 a share, the option seller is bound to sell you the shares at that price.
Decision
In this case, you purchased a call option on the Luis1k stock with a strike price of $100 and an expiration date of one month from now. The option premium was $5 per share, therefore you paid a total of $500 for the option (100 shares x $5 premium).
If you do next is determined on your expectations for Luis1k stock price. When you believe the stock price will rise over the strike price of $100 before the expiration date, you can keep the option and wait for it to expire. If the stock price rises above $100, you can exercise your option and purchase the shares at the lower price.
Covered vs naked call
Comparison
The primary distinction between a covered call and a naked call is the level of risk. With a covered call, the investor owns the underlying asset, providing a safety net if the asset’s price climbs dramatically. The investor does not own the asset while purchasing a naked call, leaving them open to limitless risk if the asset’s price increases over the strike price.
Covered calls and naked calls are two distinct options trading methods. While both techniques entail selling call options, the primary distinction is whether or not the investor owns the underlying asset. Because the investor owns the underlying asset, covered calls are regarded a less hazardous strategy, whereas naked calls are considered a high-risk strategy because the investor does not own the asset.
Covered call
A covered call strategy is one in which an investor owns a portion of the underlying asset and sells a call option on that asset. The investor is “protected” because he or she owns the asset, limiting their potential losses.
Assume an investor owns 100 shares of ABC stock, which is now trading at $50 per share. Because the investor expects the stock to remain relatively stable in the short term, he sells a call option with a strike price of $55 and an expiration date of one month from now. The investor receives a premium of $3 per share, for a total of $300.
If the stock price stays below the strike price of $55, the investor retains the premium and shares. When the stock price climbs above $55, the investor is required to sell their shares at that price, but they keep the premium from selling the call option. If the stock price climbs much above $55, the investor will miss out on possible gains above that price, but by owning the shares, they will limit their losses.
Pros
• Earns money: By selling call options against a stock you own, you can profit from the premiums received.
• Reduces risk: Because the investor already owns the underlying stock, the risk of a covered call is reduced. Even if the stock price falls, the investor can still earn from the call option premium.
• Has some potential for growth: If the stock price climbs over the strike price, the investor can still profit from the increase in value of the shares.
Cons
• Limits the stock’s potential upside profit: Selling a call option restricts the stock’s potential upside profit. If the stock price increases over the strike price, the investor must sell the stock at a cheaper price.
• Increases transaction costs: Selling covered calls necessitates several transactions, which can raise transaction costs.
• Requires larger investments: Investors must possess at least 100 shares of the underlying stock in order to sell covered calls.
Naked Call
A naked call strategy is one in which an investor sells a call option on an underlying asset that they do not own. This is a high-risk approach because the investor has no safety net if the underlying asset’s price climbs considerably.
Assume an investor feels that the Berg stock, which is presently trading at $50 a share, will fall in price in the near future. The investor sells a call option with a strike price of $55 and a one-month expiration date. The investor receives a premium of $3 per share, for a total of $300.
If the stock price continues below the strike price of $55, the premium is retained by the holder. But, if the stock price climbs over $55, the investor is required to sell the shares at that price, despite the fact that they do not own the shares. The investor would then have to purchase the shares at market price, which could be much more than the strike price, resulting in a big loss.
Pros
• Increases income: Because there is no underlying stock to protect the position, naked calls give higher premiums than covered calls.
• No need to own the underlying stock: To sell a naked call, investors do not need to own the underlying stock.
• May profit from falling stock prices: If the stock price falls, the investor earns a profit from the premium earned from selling the call option.
Cons
• Unlimited risk: Selling naked calls exposes the investor to an unlimited amount of risk if the stock price climbs above the strike price.
• Requires higher margin: Because of the additional risk, selling naked calls necessitates a higher margin than selling covered calls.
• Restricted upside potential: If the stock price climbs above the strike price, the investor must sell the stock at the lower price, reducing possible profit.
Call indicators
Some common indicators that traders may use to help inform their call option decisions:
1. Implied Volatility: Implied volatility gauges an underlying asset’s predicted volatility over a given time period. Traders may seek an asset with high implied volatility, since this may indicate a higher possibility of huge price movements, which may present profit possibilities.
2. Option Volume and Open Interest: Option volume is the number of contracts traded in a certain period of time, whereas open interest is the number of outstanding contracts that have not yet been exercised or expired. Large levels of option volume and open interest may indicate that the underlying asset is popular, which might be a good indicator for a call option.
3. Fundamental analysis: Fundamental analysis is the process of examining a company’s financial health and performance. Traders can use indicators like revenue, profitability, and market share to determine if an underlying asset is undervalued or overvalued. If a corporation is undervalued, a call option may be an excellent investment.
4. Price resistance: Price resistance is an important indicator to examine when there is unfavorable news. When an underlying asset is subjected to negative news or events, it may encounter price resistance at specific levels as investors become unwilling to buy or keep the asset.
In the midst of bad news, a trader may seek for an underlying asset that is testing or breaking through a resistance level despite the bad news. If the asset is able to break through the resistance level and continue to increase, this might be a strong indicator for a call option because it could indicate that investors are confidence in the asset’s long-term prospects despite the short-term negative news.
Call indication price
1. Strike Price: The strike price is the price at which the call option holder can purchase the underlying shares. The lower the call price, the higher the strike price.
A call option with a strike price of $50, for example, will be more expensive than a call option with a strike price of $45.
2. Time to Expiration: The higher the call price, the longer the time until the call option expires. This is because the longer the period to expiration, the more time the underlying stock has to rise in price, enhancing the call option’s potential profitability.
A call option with an expiration date one year from now, for example, will be more expensive than a call option with an expiration date one month from now.
3. Volatility: Greater volatility in the underlying stock might result in a higher call price since it enhances the possibility of price changes that benefit the call option holder.
A call option on a stock with high volatility, for example, will be more expensive than a call option on a stock with low volatility.
4. Dividends: Dividends can have an effect on the call price because they reduce the value of the underlying stock and hence the potential profitability of the call option.
A call option on a stock with substantial dividends, for example, will be less expensive than a call option on a stock with low or no dividends.
Strike pricing
Consider an investor who buys a call option on Amazon with a three-month expiration date and a $10 premium. Amazon’s stock price was $3000 at the time of purchase.
If the investor selects a strike price of $3100, the option is “out of the money” because the stock price is lower. This implies that the option has no inherent value and that the premium is solely made up of the time value of money. When the stock price continues below the strike price after three months, the option will expire worthless, and the holder would lose the $10 premium paid.
If the investor sets a strike price of $2900, the option is “in the money” since the stock price is higher than the strike price. This signifies that the option has intrinsic value, and the premium will be higher than the premium for the option with the higher strike price of $3100.
Assume the premium on the option with a strike price of $2900 is $50 due to the option’s intrinsic value. If the stock price rises to $3200 after three months, the option will be highly valuable, and the investor could sell it for a $300 per share profit, or exercise the option and buy Amazon’s stock at the lower strike price of $2900, then sell it at the market price of $3200, earning a $300 per share profit.
But, if the stock price falls below the strike price of $2900, the option would lose value, and the investor will lose money.
In this example, we can see how the strike price influences the price of a call option, with lower strike prices often resulting in higher option premiums due to the option’s intrinsic value.
Time to expiration
Consider an investor who buys a call option on Microsoft with a strike price of $200 and an expiration date of six months from the date of purchase. Microsoft’s stock price is $190 at the time of purchase, and the option premium (price) is $10.
If the investor retains the option for three months and the stock price of Microsoft rises to $220, the option is now “in the money” because the strike price of $200 is less than the current market price. The option’s premium will rise at this point due to the time worth of money and the increasing possibility of the option being exercised.
Assume that instead of waiting three months, the investor purchased an option with a one-month expiration date. Microsoft’s stock price was $190 at the time of purchase, and the option premium was $5.
If Microsoft’s stock price rises to $220 after one month, the option is “in the money,” and the investor can sell it for a profit of $15 per share or exercise it for a profit of $20 per share.
But, if the stock price does not rise or even falls, the option will lose value owing to the time value of money, and the investor may lose money.
In this example, we can see how the time to expiration affects the price of a call option, with longer expiration dates typically resulting in larger option premiums due to the increased time value of money.
Volatility
Consider an investor who buys a call option on Apple with a strike price of $150 and a three-month expiration date. Apple’s stock price is $140 at the time of purchase, and the option premium is $10.
If the market continues generally consistent over the following three months and Apple’s stock price remains reasonably stable, the option may expire out of the money and be worthless. The investor loses the entire premium paid in this case.
But, if the market is volatile and Apple’s stock price fluctuates significantly over the next three months, the option may become “in the money” and grow in value. Assume that the stock price rises to $170, putting the option “in the money.” The option premium may rise in this instance due to the greater possibility of the option being exercised.
Assume the option premium rises to $30 as the stock price and volatility rise. The investor might execute the option and buy Apple’s stock at the lower strike price of $150, then sell it at the market price of $170, generating a profit of $20 per share.
On the other hand, if the market is volatile and Apple’s stock price falls over the next three months, the option’s value may fall and it will expire out of the money. The investor would lose the entire premium paid in this case.
We can see how volatility can affect the price of a call option in this example, with higher volatility generally resulting to higher option premiums due to the increased possibility of the option being exercised.
Dividend
Consider an investor who buys a call option on Microsoft with a strike price of $250 and a three-month expiration date. Microsoft’s stock price is $260 at the time of purchase, and the option premium is $10.
Assume Microsoft declares a $2 per share dividend payable two months before the option expiration date. This means that dividends will be paid to shareholders who own Microsoft stock on the dividend record date.
The investor is not entitled for the dividend because they do not hold Microsoft stock. Nonetheless, the dividend announcement may have an impact on the option’s price. This is because the stock’s value is predicted to fall by the dividend amount on the ex-dividend date, which is normally two business days before the dividend record date.
Assume the ex-dividend date is in one month, and the option premium is adjusted to reflect the predicted fall in stock price as a result of the dividend announcement. The option price may be reduced by the dividend amount, or $2 per share, bringing the premium down to $8.
If the investor exercises the option before the ex-dividend date, they will be ineligible for the dividend. But, if the investor waits until after the ex-dividend date and the stock price falls by $2 per share, the option may become more attractive. In this situation, the investor might either sell the option for a bigger premium or exercise it and buy Microsoft’s stock at the lower strike price, then sell it at the market price to profit.
On the other hand, if the stock price does not fall by the amount of the dividend or the option is out of the money, the option may expire worthless, resulting in the investor losing the whole premium paid.
We can see how dividends can affect the price of a call option in this example, with dividend announcements often resulting in a fall in the option premium due to the predicted decline in the stock price.
Picking a stock
• Financial statement: Investors should evaluate the company’s financial statements, which include the balance sheet, income statement, and cash flow statement. Companies with good financials, such as stable revenue and profits growth, low debt-to-equity ratios, adequate cash reserves, should be sought after.
• Trends in the Industry: It’s critical to think about broader industry trends and how they can affect the company’s growth potential. Is the industry expanding or shrinking? Is the company well positioned to benefit from these trends?
• Competive advantage: Investors should examine the company’s competitive landscape and determine its position in relation to its competitors. Do they have a distinct advantage or competitive advantage? Is there strong competition or a threat from new entrants?
• Market Sentiment: In addition to focusing on the company’s fundamentals, evaluate the broader market sentiment and how it may effect the stock price. Investors should keep an eye on market trends, news, and sentiment to see how the market will react to the stock.
So it’s not any different then picking a stock for a longterm investment only when you have a good sentiment towards a company then shares should be bought for a call.
Long vs short call
| Long call | Short call | |
|---|---|---|
| Investor’s Position | Bullish1 | Bearish2 |
| Risk | Limited to premium paid | Unlimited |
| Reward | Potentially unlimited | Limited to premium received |
| Breakeven Point | Strike price + premium paid | Strike price + premium received |
| Obligation | None | Obligation to sell stock at the strike price |
| Time Decay | Losses premium over time | Profits premium over time |
| Example | An investor buys a call option on Apple at $150 | An investor sells a call option on Apple at $150 |
Assume an investor purchases a call option on Apple with a strike price of $150 and a one-month expiration date. Apple’s stock price is $140 at the time of purchase, and the option premium is $5.
If the price of Apple’s stock rises above the striking price of $150 before the expiration date, the option becomes “in the money,” and the investor can exercise the option and buy Apple’s stock at the lower strike price, then sell it at the higher market price to profit. The potential gain for the investor is unlimited because the stock price could continue to climb, but their risk is restricted to the $5 premium paid.
In contrast, if the investor sells a call option on Apple with a strike price of $150 and an expiration date of one month, they will earn a $5 premium as income. If Apple’s stock price rises over the $150 strike price, the option becomes “in the money,” and the investor is required to sell the stock at the lower strike price.
Their potential profit is restricted to the $5 premium received, but their risk is unlimited because the stock price could rise further, resulting in a loss for the investor.
In summary, a long call option entitles the holder to purchase the underlying asset, whereas a short call option requires the writer to sell the underlying asset.
Call expiring
Assume an investor buys a call option with a strike price of $3,500 and an expiration period of one month on Amazon. Amazon’s stock price is $3,550 at the time of purchase, and the option premium is $100.
If the investor does not exercise the option before the expiration date and Amazon’s stock price remains below the strike price of $3,500, the option will expire worthless. In this case, the investor would lose the full $100 premium paid for the option.
If Amazon’s stock price rises over the strike price of $3,500 before the option expires, it may become “in the money.” In this example, the investor might execute the option by purchasing Amazon’s shares at the lower strike price and then selling it at the higher market price to profit.
It’s worth noting that investors are not required to exercise a call option if it gets “in the money.” They can choose to benefit by selling the option rather than purchasing the underlying shares. This is referred to as closing the option position.