Invest Alpha

Call Option

What Are Call Options?

A call option is a financial contract that gives the holder the right, but not the obligation, to buy an underlying asset (such as stocks, commodities, or indexes) at a predetermined price (called the strike price) within a specified time frame. The buyer of a call option expects the price of the underlying asset to increase, while the seller (or writer) of the call option anticipates the price will remain the same or decrease, allowing the contract to expire worthless.

The buyer pays a premium to the seller for this right. If the price of the underlying asset rises above the strike price, the buyer can purchase the asset at the lower strike price and sell it at the higher market price, making a profit. If the asset’s price stays below the strike price, the call option expires worthless, and the buyer loses only the premium paid.

Example of a Call Option

Suppose Company ABC’s stock is currently trading at $50 per share. You believe the stock price will rise in the next month and buy a call option with a strike price of $55, expiring in 30 days, for a premium of $2 per share. The contract covers 100 shares, so you pay $200 for the option ($2 × 100).

  • If the stock price rises to $60: You can exercise the option, buying the shares at $55 and selling them at $60. Your profit is:($60 – $55) × 100 shares – $200 premium = $300.
  • If the stock price stays at $50: The call option expires worthless, and your loss is the $200 premium paid.

Strategies Using Call Options

  1. Covered Calls – A covered call strategy involves owning the underlying asset and selling a call option on it. This generates income from the premium but caps potential upside if the stock price rises above the strike price. Example: You own 100 shares of XYZ stock, currently trading at $70 per share. You sell a call option with a $75 strike price for $3 per share. If the stock stays below $75, you keep the premium. If it rises above $75, your shares will be sold at $75, and your upside gain is capped.
  2. Long Calls – A long call is used when an investor expects a significant increase in the price of the underlying asset. This involves simply buying a call option. Example: A stock is trading at $100, and you buy a call option with a strike price of $110 for a premium of $4. If the stock rises to $120, your profit is ($120 – $110) – $4 = $6 per share.
  3. Short Calls (Naked Calls) – Selling (writing) a call option without owning the underlying asset is a high-risk strategy. The writer hopes the stock price stays below the strike price to retain the premium. If the stock price rises significantly, losses can be unlimited. Example: A stock is trading at $90, and you sell a call option with a $95 strike price for $3. If the stock stays below $95, you keep the $3 premium. If the stock rises to $100, your loss is ($100 – $95) – $3 = $2 per share.
  4. Bull Call SpreadThis strategy involves buying a call option at a lower strike price and simultaneously selling a call option at a higher strike price. It is used to profit from a moderate price increase while limiting costs. Example: A stock is trading at $50. You buy a $45 strike call for $7 and sell a $55 strike call for $3. Your net cost is $4. If the stock rises to $55 or higher, your profit is ($55 – $45) – $4 = $6 per share.
  5. Straddle or Strangle (using Calls) – These strategies involve combining calls with puts to benefit from large price movements in either direction. Example: A stock is trading at $50. You buy a $50 strike call for $4 and a $50 strike put for $3 (straddle). If the stock moves significantly above $57 or below $43, one leg of the trade will generate enough profit to offset the other’s loss, potentially leading to a net gain.