What is a call option? A single call stock option gives the buyer the right but not the obligation (except at expiration) to purchase 100 shares of the underlying stock for a set price (the strike price). Some options can’t be settled with the purchase of the underlying like an index (you can’t buy an index!), in which case the option would be settled in cash and is referred to as an index option. Call options are limited by time, of course, meaning that they have an expiration date associated with them, as do all options. Let’s take a look at an example:
Let’s say that IBM is trading for 100. You look an options chain and see that you can buy one call option contract for the 105 strike which expires in 30 days for $2. This gives you right to buy 100 shares of IBM for $105 per share for the next 30 days.
Why would someone buy this call if IBM is trading $5 lower than your strike price?
One reason is cost. If you thought IBM was going up in the next few days and you wanted to purchase 100 shares, it would cost you $10,000 dollars at the current price of $100 in this example. However, you could control those same 100 shares with the call option for only $200. So if you are correct and IBM does go up to, say, $110 before it expires, you could exercise your call option thereby allowing you to buy IBM for $105—and immediately sell it for $110 and lock in your $5 profit per share.
However, another choice you have is to just sell (or close) your option position. Your option would have at least a value of $5 plus any time value remaining allowing you to sell the option for, say $6 ($5 intrinsic value plus $1 of remaining time value). Since you paid $2 per option and sold it for $6 you make $4 or 200% on your trade, vs. less than 5% if you purchased the stock outright with much more capital.
Other possible scenarios:
1) IBM goes up a few points immediately after you purchase it. So even if it does not go to $105, your call option will most likely appreciate in value allowing you to exit at a profit. Although you will have a profit, option pricing on your sale may be affected somewhat by a drop in volatility and time decay.
2) IBM stays at 100, or goes down after you purchase your call option. Your option will start to lose value due to IBM going down and due to loss in time value (as we have covered previously also known as time decay) as every day passes, offset by a probable slight increase in volatility.
3) IBM goes to $106 and you hold your option into expiration. Since IBM can be settled with stock, you will be forced to purchase the stock for $105. This is called “Exercise by Exception” which means that if your option is $.01 in the money (IBM at $105.01) you will be assigned the shares automatically at expiration. Not only will you lose money on the trade if IBM opens after you are assigned the shares at $105 (because you paid $2 for your option, yet you can only sell your shares for the same price you were forced to buy them–$105– thus you suffer a loss of $2 per share), you will have also taken on a downside risk—the risk of IBM opening the following day down—in which case you would lose even more. So always make sure that you close out your options before expiration to avoid this unintended risk of assignment.
There are two different exercise methods: European and American. European style options can only be exercised at expiration. American-style options can be exercised at any time. Most indexes use European-style expiration since there is not an underlying asset to purchase and thus would be settled in cash.
Call options can be purchased for many different asset classes including stocks, indexes, ETFs, futures and commodities (like gold and silver). In conclusion, there are many different uses of call options but the buyer must be aware of time value, volatility, and the potential for assignment in certain cases and the risks of each of those factors.
Seth Freudberg,
Director, SMB Options Training Program
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