What are Call Options?
A call option is a contract between two parties that gives the holder the right, but not the obligation, to purchase an asset at a specific price (strike price) by a specific date in the future (expiration date). For this right, the call buyer will pay an amount of money (the premium), which the call seller will receive for taking that risk.
Let’s think of options in another way before we dive in. Imagine a potential homeowner sees a new building development going up that they are interested in. They are not sure about fully committing to the property but want the right to purchase a home in the future and would only want to exercise that right once certain conditions have been met, e.g the development is completed or they have seen how the marketplace performs in that time.
Imagine the buyer can buy a call option from the developer which allows them to buy the home at £500,000 at any point in the next three years. In the property world, this would be seen as a non-refundable deposit as the developer wouldn’t grant such an option for free as they would also be taking a risk. The potential home buyer needs to contribute a down payment to lock in that right. To a buyer, if the value of the property goes up, they have locked in the price of £500,000. If the value significantly decreases then they have the option to pull out and lose the deposit, buy the house anyway at the lower market price, or simply walk away.
Call Option Explained
A call option can be purchased if the buyer thinks the underlying market is going to go up in price. The biggest advantage of buying a call option is that it magnifies the gains in a stock’s price using leverage. For a relatively small upfront cost, you can enjoy exposure to a stock’s gains above the strike price until the option expires. A call option is in profit when the underlying asset price is above the sum of the strike price and premium paid at expiration. The call owner can either:
- a) exercise the option at expiry (if a European option) or anytime (if an American option), putting up cash to buy the stock at the strike price; or
- b) can simply sell the option at its fair market value to another buyer through the exchange at any point prior to expiry.
If a buyer decides to buy a call option with a strike price of 420 for 18, the buyer has the right, but not the obligation to buy shares at 420 by exercising the option before the end of the contract expiry. This becomes valuable if the underlying share price has gone above the 420 strike price and is now trading at say 460, as technically you will be able to exercise your option purchasing shares at 420 and immediately sell them in the market at 460; or you could sell your option at its fair market value which should be around 40.
Call Option Summary
- If the price of the underlying stock goes above your break-even price, you are “in profit” and can crystalise your profit by selling your option
- Break-even Price = Call Option Strike Price + Premium Paid
- If the price of the underlying stock goes below your strike, your option is “out of the money”, and at expiry your option will be worthless. You will lose the price you paid to hold the call. You bought the 420 call at 18, you lose 18, which in this case is about 4% of the underlying asset price.
- Maximum Loss = Limited to the premium paid for the option.
- If the price of the underlying stock goes above your strike, your option is “in the money” (the difference between the strike price and underlying stock price). If this is greater than the premium paid (18) then your option is in profit. If the underlying price is 460 then your profit is 22 or 5.2% (460-420-18).
- Maximum profit = Technically unlimited
- Buying a Call option
- Bullish, volatility rising
- Underlying asset being higher than the Call strike bought – premium paid
- Defined risk strategy
- Unlimited profit potential
- Premiums can erode quickly is a neutral or falling market
- Can be relatively expensive at outset
- Market timing very important