Call Option

[Igor 10]

A call order is one of two types of orders that an option trader can make (the other being a put order). The trader can either choose to buy a call option or sell one.

 

Buyer: The call option buyer has the right to buy the underlying asset, but is in no way obligated to do so. The call option buyer can choose to either exercise his right to buy on or before the call option's strike date, or they can let the option expire.

 

Seller: The call option seller (writer) has the obligation to sell the underlying asset at its strike price, if a buyer exercises their right on or before the option's expiration date. The seller receives a premium (option market price) from the buyer for taking this risk.

Both buying and selling call options are high-risk investments, with traders who buy taking the higher gamble. A trader may ask, if call options are so risky, why do investors buy and sell them? The answer is in the return, because even though the risk is high, call options can give investors high profits when performed correctly.

 

What Is a Call Option?

A call option is a contract that's connected to an underlying asset, normally a stock or commodity. Every call option contract has a fixed price (strike price) that each trader must honor on or before a fixed date (strike date). The terms and responsibilities under the contract differ depending on whether the trader is the buyer or the seller.

 

Buying a Call

Traders who buy call options are betting that the market price of the underlying asset will go up. Call options carry a premium, which varies depending on price and how close the purchase is from the strike date. Usually, one call option contract gives the buyer the right to buy 100 shares of the underlying asset. A call buyer pays a premium for each share covered under the call contract. If the asset's market price exceeds the call option's strike price, the call buyer will exercise his right to buy the shares. If the market price is lower, they will just let the option expire, resulting in a loss in whatever they paid in premiums.

 

Example: GE is trading at $48 (market price)

1) Option Available: GEJan50($5) = 100 shares of GE stock at $50/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $5.

2) Call buyer has $5500 in their investment account.

3) Trader buys 1 call option at $500 (100 x $5 (premium cost)).

 

Result one: GE hits $70. The call option buyer exercises their right to buy 100 shares at $50. Their total investment is $5,500 ($5000 shares + $500 premium). They immediately sell their 100 shares for $7000, resulting in $1500 profit (300%).

 

Result two: GE hits $30. The call option buyer lets the contract expire, does not exercise their right to buy and loses the amount of premiums paid. In this example, the option buyer would lose $500.

 

Selling a Call

Traders who sell call options are betting that the market price of the underlying asset will go down. Call options carry a premium that goes directly to the seller. If a call buyer does not exercise their option, the call seller keeps both the asset and the premium. On the contrary, call option buyers who exercise the option, obligate the call seller to sell the underlying asset.

 

There are two types of call sales. A covered call is a sale in which the seller actually owns the asset. Traders make naked calls when they do not own the underlying asset. Naked calls have the highest risk and only expert traders should carry out this kind of strategy.

 

Covered Call

A covered call is a win-win strategy for traders who have the capital to own the underlying asset. Covered call sellers make a profit when the market price goes up and buffer losses when it goes down, by writing the call option with a strike price higher than its market price.

 

Example: GE is trading at $50 (market price)

1) Call seller has $5000 in their investment account and buys 100 shares of GE.

2) Call seller writes the option: GEJan52($2) = 100 shares of GE stock at $52/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2.

3) Call buyer buys the option and call seller receives $200 in premiums.

 

Result one: GE hits $70. The call option buyer exercises their right to buy 100 shares at $52. The call seller sells at $5200 and receives $400 profit ($200 in premiums + $200 from price)

 

Result two: GE hits $40. The call option buyer lets the contract expire. In this example, the option seller would keep the asset, keep $200 in premiums, but would suffer a $1000 loss from the asset's current market price. The total loss reduces to $800 when adding the premium.

 

Naked Call Options

This type of call option is one of the highest risks a trader can make. It involves writing a call on an asset that is not owned. The naked call writer will need to buy shares if the call buyer exercises the option.

 

Example: GE is trading at $50 (market price)

1) Call seller writes the option: GEJan52($2) = 100 shares of GE stock at $52/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $5.

2) Call buyer buys the option and call seller receives $500 in premiums.

 

Result one: GE hits $70. The call option buyer exercises their right to buy 100 shares at $52. The call seller needs to buy 100 shares to cover the option and pays $7,000. They deliver the shares and receive $5,200 from the call buyer, resulting in a loss of $1,800. The total loss reduces to $1,200 when adding the premiums received at the beginning of the sale.

 

Result two: GE hits $40. The call option buyer lets the contract expire. In this example, the option seller would keep the asset, and make $500 in profit from premiums.

The lower a naked call seller's strike price deviates from the asset's market price, the higher premium the seller will receive, but if the buyer exercises the option, total loss also increases.

 

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