Call Options: Learn The Basics Of Buying And Selling | Bankrate (2024)

In this article

  • What is a call option?
  • Call options explained: How they work
  • Why buy a call option?
  • Why sell a call option?
  • Call options vs. put options

Call options are a type of option that increases in value when a stock rises. They’re the best-known kind of option, and they allow the owner to lock in a price to buy a specific stock by a specific date. Call options are appealing because they can appreciate quickly on a small move up in the stock price. So that makes them a favorite with traders who are looking for a big gain.

What is a call option?

A call option gives you the right, but not the requirement, to purchase a stock at a specific price (known as the strike price) by a specific date, at the option’s expiration. For this right, the call buyer pays an amount of money called a premium, which the call seller receives. Unlike stocks, which can live in perpetuity, an option will cease to exist after expiration, ending up either worthless or with some value.

The following components comprise the major traits of an option:

  • Strike price: The price at which you can buy the underlying stock
  • Premium: The price of the option, for either buyer or seller
  • Expiration: When the option expires and is settled

One option is called a contract, and each contract represents 100 shares of the underlying stock. Exchanges quote options prices in terms of the per-share price, not the total price you must pay to own the contract. For example, an option may be quoted at $0.75 on the exchange. So to purchase one contract it costs (100 shares * 1 contract * $0.75), or $75.

Call options explained: How they work

Call options are “in the money” when the stock price is above the strike price at expiration. The call owner can exercise the option, putting up cash to buy the stock at the strike price. Or the owner can simply sell the option at its fair market value to another buyer before it expires.

A call owner profits when the premium paid is less than the difference between the stock price and the strike price at expiration. For example, imagine a trader bought a call for $0.50 with a strike price of $20, and the stock is $23 at expiration. The option is worth $3 (the $23 stock price minus the $20 strike price) and the trader has made a profit of $2.50 ($3 minus the cost of $0.50).

If the stock price is below the strike price at expiration, then the call is “out of the money” and expires worthless. The call seller keeps any premium received for the option.

Because of this all-or-nothing risk, financial advisors generally advise investors to avoid using options in their retirement accounts such as an IRA.

Why buy a call option?

The biggest advantage of buying a call option is that it magnifies the gains in a stock’s price. For a relatively small upfront cost, you can enjoy a stock’s gains above the strike price until the option expires. So if you’re buying a call, you usually expect the stock to rise before expiration.

Imagine that stock XYZ is trading at $20 per share. You can buy a call on the stock with a $20 strike price for $2 with an expiration in eight months. One contract costs $200, or $2 * 1 contract * 100 shares.

Here’s the trader’s profit at expiration.

As you can see, above the strike price the value of the option (at expiration) increases $100 for every one dollar increase in the stock price. As the stock moves from $23 to $24 – a gain of just 4.3 percent – the trader’s profit increases by 100 percent, from $100 to $200.

While the option may be in the money at expiration, the trader may not have made a profit. In this example, the premium cost $2 per contract, so the option breaks even at $22 per share, the $20 strike price plus the $2 premium. Only above that level does the call buyer make money.

If the stock finishes between $20 and $22, the call option will still have some value, but overall the trader will lose money. And below $20 per share, the option expires worthless and the call buyer loses the entire investment.

The appeal of buying call options is that they drastically magnify a trader’s profits, as compared to owning the stock directly. With the same initial investment of $200, a trader could buy 10 shares of stock or one call.

If the stock finishes at $24, then…

  • The stock investor makes a profit of $40, or (10 shares * $4 gain).
  • The options trader makes a profit of $200, or the $400 option value (100 shares * 1 contract * $4 value at expiration) minus the $200 premium paid for the call.

When comparing in percentage terms, the stock returns 20 percent while the option returns 100 percent.

Why sell a call option?

For every call bought, there is a call sold. So what are the advantages of selling a call? In short, the payoff structure is exactly the reverse for buying a call. Call sellers expect the stock to remain flat or decline, and hope to pocket the premium without any consequences.

Let’s use the same example as before. Imagine that stock XYZ is trading at $20 per share. You can sell a call on the stock with a $20 strike price for $2 with an expiration in eight months. One contract gives you $200 ($2 * 1 contract * 100 shares).

Here’s the trader’s profit at expiration.

The payoff schedule here is exactly the opposite to that of the call buyer:

  • For every price below the strike price of $20, the option expires completely worthless, and the call seller gets to keep the cash premium of $200.
  • Between $20 and $22, the call seller still earns some of the premium, but not all.
  • Above $22 per share, the call seller begins to lose money beyond the $200 premium received.

The appeal of selling calls is that you receive a cash premium upfront and do not have to lay out anything immediately. Then you wait until the stock reaches expiration. If the stock falls, stays flat, or even rises just a little, you’ll make money. However, you won’t be able to multiply your money in the same way as a call buyer. As a call seller, the most you’ll make is the premium.

While selling a call seems like it’s low risk – and it often is – it can be one of the most dangerous options strategies because of the potential for uncapped losses if the stock soars. Just ask traders who sold calls on GameStop stock in January 2021 and lost a fortune in days.

For example, if the stock doubled to $40 per share, the call seller would lose a net $1,800, or the $2,000 value of the option minus the $200 premium received. However, there are a number of safe call-selling strategies, such as the covered call, that could be utilized to help protect the seller.

Call options vs. put options

The other major kind of option is called a put option, and its value increases as the stock price goes down. So traders can wager on a stock’s decline by buying put options. In this sense, puts act like the opposite of call options, though they have many similar risks and rewards:

  • Like buying a call option, buying a put option allows you the opportunity to earn back many times your investment.
  • Like buying a call option, the risk of buying a put option is that you could lose all your investment if the put expires worthless.
  • Like selling a call option, selling a put option earns a premium, but then the seller takes on all the risks if the stock moves in an unfavorable direction.
  • Unlike selling a call option, selling a put option exposes you to capped losses (since a stock cannot fall below $0). Still, you could lose many times more money than the premium received.

For more, see everything you need to know about put options.

Bottom line

While call options can be risky, traders do have ways to use them sensibly. In fact, if they’re used correctly, options can limit risks while still allowing you to still profit from the gain or loss on a stock. Of course, if you still want to try for a home run, options also offer you that opportunity, too. The best brokers for options can get you started quickly and at low cost.

Call Options: Learn The Basics Of Buying And Selling | Bankrate (2024)

FAQs

Call Options: Learn The Basics Of Buying And Selling | Bankrate? ›

A call option gives you the right, but not the requirement, to purchase a stock at a specific price (known as the strike price) by a specific date, at the option's expiration. For this right, the call buyer pays an amount of money called a premium, which the call seller receives.

What are the basics of buying call options? ›

What are call options? A call option is a contract between a buyer and a seller to purchase a certain stock at a certain price up until a defined expiration date. The buyer of a call has the right, not the obligation, to exercise the call and purchase the stocks.

How to learn options trading basics? ›

  1. How to Trade Options in 5 Steps.
  2. 1.Assess Your Readiness.
  3. 2.Choose a Broker and Get Approved to Trade Options.
  4. 3.Create a Trading Plan.
  5. 4.Understand the Tax Implications.
  6. 5.Continuous Learning and Risk Management.
  7. Buying Calls (Long Calls)
  8. Buying Puts (Long Puts)

What are the basics of call and put options? ›

A call option gives the buyer the right, but not any obligation, to buy a particular stock at a pre-defined price on the expiration date. A put option gives the right to an investor, but not an obligation, to sell a particular stock at a predetermined rate on the expiration date.

What is the trick for option trading? ›

Avoid options with low liquidity; verify volume at specific strike prices. calls grant the right to buy, while puts grant the right to sell an asset before expiration. Utilise different strategies based on market conditions; explore various options trading approaches.

How do call options work for dummies? ›

Call options give the buyer the right to purchase 100 shares of stock at a specific price. The price that is agreed upon is known as the strike price. As an options trader, you can use calls to leverage your portfolio. Unlike shares of stock, options contracts eventually expire on their expiration date.

What is the best call option strategy? ›

A Bull Call Spread is made by purchasing one call option and concurrently selling another call option with a lower cost and a higher strike price, both of which have the same expiration date. Furthermore, this is considered the best option selling strategy.

How fast can I learn option trading? ›

Well, it really depends on how much time and effort you're willing to put in. Some people might be able to pick it up in a few weeks, while others might take months or even years to fully grasp the concepts. But, one thing that can definitely speed up the learning process is by learning from the right sources.

How to learn options buying? ›

In case the stock rises above the strike price, your option is likely to be in the money. This is how you can learn more about options trading in India. In the same way, if you suspect that the share price of the company is falling to Rs. 6,621, it is best to purchase a put option with a strike price above this.

Which option strategy is best for beginners? ›

5 options trading strategies for beginners
  1. Long call. In this option trading strategy, the trader buys a call — referred to as “going long” a call — and expects the stock price to exceed the strike price by expiration. ...
  2. Covered call. ...
  3. Long put. ...
  4. Short put. ...
  5. Married put.
Mar 28, 2024

What is an example of buying a call option? ›

Suppose you purchase a call option for company ABC for a premium of $2. The option's strike price is $50, with an expiration date of Nov. 30. You will break even on your investment if ABC's stock price reaches $52—meaning the sum of the premium paid plus the stock's purchase price.

What is a call option in simple terms? ›

A call option is a contract that gives the owner the option, but not the requirement, to buy a specific underlying stock at a predetermined price (known as the “strike price”) within a certain time period (or “expiration”). For this option to buy the stock, the call buyer pays a “premium” per share to the call seller.

How do I sell call and put options? ›

When you sell an option, you give away the right to decide, and you accept an obligation. That's the trade-off. Selling put options. You collect the premium, but you may have the obligation to buy the underlying at the strike price if it trades below that price at or before expiration.

How do you never lose in option trading? ›

The option sellers stand a greater risk of losses when there is heavy movement in the market. So, if you have sold options, then always try to hedge your position to avoid such losses. For example, if you have sold at the money calls/puts, then try to buy far out of the money calls/puts to hedge your position.

Is it difficult to learn options trading? ›

You see, it's very easy to categorize options as difficult to understand, but knowing just a few basic characteristics about options makes them very useful and easy to understand. Anyone—meaning absolutely anyone—can learn how to confidently trade options.

What not to do when trading options? ›

If you want to trade options, be sure to avoid these common mistakes.
  1. Not having a trading strategy. ...
  2. Lack of diversification. ...
  3. Lack of discipline. ...
  4. Using margin to buy options. ...
  5. Focusing on illiquid options. ...
  6. Failing to understand technical indicators. ...
  7. Not accounting for volatility. ...
  8. Bottom line.
Feb 5, 2024

How do you make money buying call options? ›

A call option buyer stands to profit if the underlying asset, say a stock, rises above the strike price before expiry. A put option buyer makes a profit if the price falls below the strike price before the expiration.

What is the risk of buying a call option? ›

The risk of buying the call options in our example, as opposed to simply buying the stock, is that you could lose the $300 you paid for the call options. If the stock decreased in value and you were not able to exercise the call options to buy the stock, you would obviously not own the shares as you wanted to.

When to buy calls and puts? ›

Typically, you use call options when you think a stock will go up. You use put options when you think a stock will go down. While typical, this isn't always the case. You can express negative sentiment on a stock via call options and positive sentiment with put options.

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