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What is a Call Option (Definition)?

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 price).

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.

Risk

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.

Profit Potential

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.

Covered Calls

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 situations.

Learn more at www.brokerjobs.com/calloption.htm

Good Luck!