Call Options
Call options give the buyer the right, but not the obligation, to
purchase an underlying asset. They are available in various strike prices
depending on the current market price of the underlying instrument.
Expiration dates can vary from one month out to more than a year (LEAPS
options). Depending on the mood of the market, you may choose to buy (go
long) or sell (go short) a call option.
If you choose to buy or go long a call option, you are purchasing the
right to buy the underlying instrument at the chosen strike price until
expiration. The premium of a long call option shows up as a debit in your
trading account. The premium amount represents the maximum risk a long
call strategy can incur. Profit is usually made on a long call when the
price of the underlying asset rises above the strike price of the call.
You can then either exercise the call or offset it by selling a call with
the same strike price and expiration date. By exercising a long call, you
generally end up with 100 shares per option of the underlying stock at the
call strike price. You can then turn around and sell the underlying asset
at the current (higher) price to garner a profit on the difference between
two (current price - strike price = profit). If you choose to offset the
call option, the maximum profit is unlimited. The call's premium will
increase in value depending on how high the underlying instrument rises in
price beyond the strike price of the call. As the price of the underlying
asset rises, the long call becomes more valuable because it gives you (or
the person you sell it to) the right to buy the underlying stock at the
lower strike price of the call. That's why you want to go long a call
option in a rising or bull market.
If you choose to sell or go short a call option, you are selling the
right to buy the underlying instrument at a particular strike price to an
option holder. Selling a call option prompts the deposit of a credit in
your trading account in the amount of the call's premium. This is a
limited profit strategy. You get to keep this credit if the option expires
worthless. Thus, to make money on a short call, the price of the
underlying asset must stay below the call's strike price. If the price of
the underlying asset rises above the short call strike price, it will
likely be assigned. This means that the call option seller is required to
deliver the option package (usually 100 shares of stock) at the strike
price.
After assignment, the individual will be short those shares unless they
already had a long position in the stock. The option seller may need to
buy the underlying stock at the current market price after selling it at
the call's lower strike price, thereby incurring a loss on the trade
(current price - strike price = loss). The maximum loss is therefore
unlimited to the upside, which is why selling "naked" or
unprotected call options comes with such a high risk.
Call options give you the right to buy something at a specific price
for a specific time period. If the current market price is more than the
strike price, the call option is in-the-money (ITM). If the current market
price is less than the strike price, the call option is out-of-the-money
(OTM). If the current market price is the same as (or close to) the strike
price, the call option is at-the-money (ATM).
Example: A local newspaper advertises a sale on VCRs for
only $129.95. The next day Jane goes down to the electronics store
intending to purchase a VCR at the advertised price. Unfortunately,
by the time she arrives, the VCR is already out of stock. The
manager apologizes and gives her a rain check entitling Jane to buy
the same VCR for the advertised price of $129.95 anytime within the
next two months. Jane has just received a long call option which
gives her the right, but not the obligation, to purchase the VCR at
the guaranteed strike price of $129.95 until the expiration date two
months away.
Scenario 1: A few weeks later, Jane return's to the
store to exercise her rain check. The same VCR is now in stock,
priced at $179.95. Jane approaches the store manager who agrees to
honor the rain-check and sell her a VCR for the advertised price of
$129.95. Jane has just saved $50. Her long call option was
in-the-money.
Scenario 2: A few weeks later, Jane returns to the
store and finds the VCR on sale for $119.95? Her rain check is now
worthless because she can simply purchase the VCR at the reduced
price. In this case, Jane's call option expired worthless because it
was out-of-the-money. Just because you own a long call option
doesn't mean you are under any obligation to use it.
Scenario 3: Jane's friend Jeff phones and mentions
that his VCR has just broken. She tells him about her rain-check and
agrees to sell it to Jeff for $5 (the option premium). The strike
price is still $129.95 and the expiration date is 2 months out.
However, Jeff is taking a risk. The VCR might be priced lower than
the $129.95 strike price in which case the rain-check is worthless
and Jeff loses $5. |
Call Option Review
Call options give traders the right to buy the underlying stock at the
strike price until their broker’s cut-off time shortly after market
close on the last trading day before expiration. A call option is
in-the-money (ITM) if its strike price is below the current price of the
underlying stock. A call option is out-of-the-money (OTM) if its strike
price is above the current price of the underlying stock. A call option
is at-the-money (ATM) if its strike price is the same as (or close to)
the current price of the underlying stock.
Buying Calls (long-bullish). The trader believes the market will rise
and buys (go long) calls. Buyers have rights. A call buyer has the
right, but not the obligation, to buy the underlying stock at the strike
price until the expiration date. If you buy a call option, your maximum
risk is the money paid for the option, the debit. The maximum profit is
unlimited depending on the rise in the price of the underlying asset. To
offset a long call, you have to sell a call with the same strike price
to close out the position. By exercising a long call, you are choosing
to purchase 100 shares of the underlying stock at the strike price of
the call option.
Selling Calls (short-bearish). The trader believes the market will
fall and sells (goes short) calls. Sellers have obligations. A call
seller has the obligation to sell 100 shares of the underlying stock at
the strike price if assigned. If you sell a call option, your risk is
unlimited to the upside. The profit is limited to the credit received
from the sale of the call. When selling calls, make sure to choose
options with little time left until expiration. Call sellers want the
call to expire worthless so that they can keep the whole premium. To
offset a short call, you have to buy a call with the same strike price
to close out the position.
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