Call Option Explained

Call Option Explained

Call Option Explained

A Call option provides the buyer with the right, but not the obligation, to buy the underlying security at the strike price.

Call options can be used in a variety of ways. The purpose of this article is to introduce you to some of the basic uses of a call option and how they can be used in your option trading.

Using A Call Option To Buy Stock

A call option vests the option buyer with the right to purchase the underlying security at predefined the strike price. That right is limited to a specified time period, defined by the option contract's expiration date.

On occasion you may be interested in buying stock, but you may be concerned about tying up a significant portion of your capital. Assume you are bullish on XYZ Corporation and you would like to buy 500 shares of stock. The current share price of $30 means that you would have to allocate $15,000 to the position. If using margin, you could make the purchase with just $7,500 in capital. You want to own the stock because you expect that it will move higher in price over the next several months.

An alternative approach to buying the stock is to purchase a call option, which allows you to benefit from upward price movement in the stock and, if you choose, to later acquire the stock. Assume you can buy an XYZ $30 Call option with six months left to expiration for $3.00. The capital requirement for this purchase is 10% of the current cost of the stock.

If your analysis is correct and the stock trades higher, you may exercise your rights under the contract and purchase the stock at $30 per share. You effectively enter the stock position with a built in profit. On the surface this seems simple and straight forward, but in practice choosing an appropriate option requires a good working knowledge of options fundamentals.

Limiting Risk With Call Options

The maximum risk of your stock position in the above example is $15,000, regardless of whether you use margin or make the purchase in cash. A stop loss order can be used to limit risk, but it provides no guarantee that your order will execute at the designated price.

Buying a call option allows you to control the stock without taking on all of the risk associated with stock ownership. Your risk is limited to $1,500 ($3.00 * 500) or just 1/10th the exposure of owning the stock. No matter how far the stock price falls, you can never lose more than your original purchase price. This is referred to as the "risk profile," which can be graphed.

The image below displays a risk graph for our long call position. The horizontal blue line represents break-even; the point at which you have neither lost or made money on the trade. The angled black line represents the value of your call option at expiration. The prices running horizontally along the bottom of the graph represent the price of the underlying stock. The vertical line in the blue shaded area is the current stock price.

As the stock price moves higher the value your call option begins to rise. Note the multi-colored curved lines. Those represent different points of time in the life of your call option. As expiration approaches value is lost through theta decay.

You will note that the maximum risk in the trade is limited to a few hundred dollars, which is simply the price that was paid for the option contract. If the call option is held until expiration (black line) and the stock price does not advance sufficiently, then the option expires worthless.

Call Option Explained

Using A Stock Option To Leverage Profits

In addition to reducing your risk, using a call option has also provides you with leverage from which to enhance profits. Referring again to our example trade, let's assume that XYZ has increased in price to $35 per share. You have the right to buy the stock at $30 per share, for which you paid $3.00.

You do not have to exercise your call option, however. You can sell your call option for which you would receive at least $5.00, because the stock is trading at $35.00 per share and your option allows you to buy for $5.00 below current market value. This represents a $2.00 profit, and a return of:

Return On Call Option
$2.00 / $3.00 = 66.6%

If you bought the stock, you would have paid $30.00 per share and earned a profit of $5.00. Your return on the stock purchase would have been:

Return On Stock Purchase
$5.00 / $30 = 16.6%

Using margin, your risk would be the same as with the cash purchase. Therefore, your return on risk is identical but your return on capital would be equal to $5.00 / $15 = 33.33%.

Review of Long Call Option Positions

By purchasing a call option, you are able to control 100 shares of stock for each option purchased. Your risk is limited to the price paid for the option, which can be significantly less than the price of the stock. The call option can be exercised to buy stock after it has appreciated or the call option can be sold.

The upside profit potential of a long call is effectively unlimited, which provides you with significant leverage. A nice return on a stock purchase can be a dazzling return for the call option.