What is a call option? If you’re new to options trading, this question may have crossed your mind. It is a question most face when they make their entry into this dynamic and lucrative space, where participants are looking to win big.
If you’re looking to navigate the world of options trading, understanding this fundamental concept is crucial. Call options are powerful financial instruments that could act as a game-changer, especially if applied correctly.
Call options offer unique opportunities for investors and traders to speculate on price movements, hedge against risks, and enhance their investment strategies.
In this article, we will deconstruct exactly what is a call option, and explore its wider significance. We also discuss how they can be utilized in different investment strategies.
So, let’s dive into the world of call options and discover how they can enhance your trading skills and help you achieve your financial goals.
What Is A Call Option?
To start off, we dive right into our question at hand; what is a call option?
Simply put, a call option is a type of financial contract that gives you the right, but not the obligation, to buy a specific amount of an underlying asset, like a stock or a commodity, at a set price within a certain timeframe.
Due to the nature by which they function, call options could basically be understood as “reservations” placed to buy an asset at a fixed date, and with a fixed price.
One of the key things to understand about call options is that they give you the right, but not the obligation, to buy the underlying asset.
This means you can choose not to exercise the option if the stock price doesn’t go up as you anticipated, and you would only lose the premium paid for the option.
What Are Puts And Calls?
Now that we have set the stage by discussing what is a call option, we can take a step back and talk about what are puts and calls.
We have mentioned that call options are essentially derivative contracts that give the holder the right, but not the obligation, to acquire an asset at a fixed price, on a fixed date.
Puts are simply the other side of the coin to this arrangement. They give the holder the right, but not the obligation, to sell an asset for a fixed price, on a fixed date.
Together, puts and calls make up the foundation of options trading. They are typically used by investors and traders to speculate on price movements in the underlying asset, manage risks, and optimize their investment portfolio.
Options traders turn to both puts and calls to achieve a number of strategic outcomes. These include hedging against potential losses, generating income through options selling, or speculating on market direction.
Buy To Open Vs Buy To Close
It is impossible to thoroughly understand what is a call option, without getting into the phenomenon surrounding ‘buy to open vs buy to close.’
Essentially, each of the two phrases introduced above reflects different processes that take place during options trading. The ‘buy to open’ process takes place when an investor initially acquires a call option.
Buy to open means a market player has entered a new call position on a particular asset, with a fixed price and fixed expiration date. The player anticipates a particular asset to climb in price, which he or she will buy at a lower price, and profit.
Alternatively, the buy to close process refers to the process of closing an existing call option position by buying back the call option contract that was previously sold.
This is typically done to exit a call option position before the expiration date. It can be used to capture profits, limit losses, or adjust an overall investment strategy.
What Is An Options Trader?
The next question we investigate is ‘What is an options trader?’. It is important to understand an options trader, as it would help shed light on the nature of options trading and the derivative market itself.
An options trader is a market player who is primarily involved in the buying and selling of derivative contracts known as options. Both calls and puts are types of options, and they are the core focus of an options trader’s activities.
An options trader uses options to speculate on the price movements of the underlying asset or to hedge their existing positions.
By using options, traders can potentially benefit from market volatility, take advantage of leverage, and construct complex trading strategies to manage risk and maximize returns.
How Do Option Calls Work?
At this point, we have not only uncovered what is a call option but have also gone over some crucial details. But all of this knowledge is meaningless without an understanding of the question, ‘How do option calls work?’.
In the steps below, we demonstrate how option calls work, and enable their holders to turn in a profit when the price of the underlying asset experiences a climb:
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Purchase an Option Call Contract
The buyer purchases an option call contract that gives them the right, but not the obligation, to buy an underlying asset at a particular strike price before a specific expiration date.
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Pay a Premium
In order to complete the purchase, a premium would need to be paid for the option call. This is the cost of the transaction and would determine the profitability of the trade.
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Watch for the Price Movement of Asset
After acquiring the option call, the holder must monitor when the price of the underlying asset climbs beyond the strike price, making it economical to exercise.
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Exercise the Call Option
When the price of the asset surpasses the strike price, the option is exercised. When doing so, the holder would essentially be buying the asset at a much lower price than what the market demands, as had been set in the contract.
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Profit
Having exercised the option and having bought the asset at a much lower price than the market, the holder would typically sell back the asset to the market at the prevalent price, and profit off the difference between the strike price and spot price.
How To Calculate Call Options Profit?
Before making a call option trade, it is important to understand how to calculate call option profit to determine the potential return on investment.
A critical variable during profit calculation in this context is the breakeven point. This refers to the strike price of the contract, plus the premium paid for acquiring it. The option will be profitable as long as the price of the underlying asset rises beyond this breakeven point.
If the current market price is higher than the break-even point, then the profit is equal to the current market price minus the break-even point minus the premium paid.
The profit through the use of call options is potentially unlimited, whereas the extent of the loss cannot go beyond the premium paid for the call option.
How To Make Money On Call Options?
Learning how to make money on call options can be a valuable skill for investors looking to profit from the price movements of underlying assets in the financial markets. Through this, traders can potentially earn significant profits in both bullish and bearish market conditions.
There are two primary ways of making money on call options. These are as follows:
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Exercising the Call Option Above Breakeven
This means exercising the call and buying the underlying asset at a price lower than the current market price and then selling it at the current market price, making a profit.
If the call option expires before the breakeven point, it may not be profitable to exercise it.
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Buy a Call Option at a Low Price and Sell it at a Higher Price
This involves buying a call option at a price lower than its true value, and selling it when its value has increased, resulting in a profit. Timing is key, as the value of the call option can fluctuate based on market conditions and other factors.
Usually, the call option would be more valuable the higher the spot price of the underlying asset is, as it would be more profitable to its holder.
Limitations
There are three primary drawbacks when it comes to call options, that options traders must be aware of, before committing to an options-based strategy. These are discussed below as follows:
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Cost Structure
Call options require an upfront premium payment, which can be costly, especially for options that are deep out of the money or have a long expiration date.
Additionally, as the expiration date approaches, the premium can increase, further limiting potential profits.
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Narrow Time Frame to Exercise
Call options have an expiration date, meaning that investors have a limited amount of time to exercise their options. If the stock price does not move in the desired direction before the option’s expiration date, investors may lose their entire investment.
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Volatility
While high volatility can potentially increase the value of call options, it can also lead to significant losses if the price of the underlying asset moves in the opposite direction.
Only traders comfortable with this degree of volatility must engage in options trading. Inexperienced traders may find it difficult to accurately predict the direction of price movements, leading to losses.
Conclusion
In this article, we have attempted to answer the question of what is a call option, in-depth. We explored the notion that call options can be valuable tools for investors looking to speculate on or hedge against potential price movements in the underlying asset.
By purchasing a call option, investors have the right to buy the underlying asset at a predetermined price, which can provide significant leverage and potential profits.
This right opens them up to unparalleled flexibility and versatility that cannot be achieved in the regular, non-derivative financial markets.
It is important to note, however, that call options come with risks, such as the possibility of the underlying asset not reaching the predetermined price or the option expiring worthless.
As with any investment, it’s crucial to do your due diligence and thoroughly understand the mechanics of call options before trading them.
FAQs
What is the Strategy of the Call Option?
The strategy of the call option is to purchase the right to buy the underlying asset at a set price and to profit from a potential increase in the asset’s value above this set price.
What are the 4 Types of Call Options?
There are four main types of call options, including American call options, European call options, long call options, and short call options.
What are the Basics of Selling Call Options?
The basics of selling call options involve selling the contract to generate income from the premium received or to hedge against an existing long position. Selling a call option also allows the seller to potentially profit if the underlying asset remains stagnant or decreases in price.
