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

As we discussed in the last lesson, a call option vests those who buy the option with the right to purchase the underlying security at the strike price.  That right is limited to a specified time period, defined by the option contract 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 stock option.  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.

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.

By buying a call option, you can control the stock without taking on the full risk.  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 on XYZ corporation.  You will note that the maximum risk in the trade is reflected at $300, reflecting a position limited to one option contract.  We could also easily graph the position for five long call options.

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.  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.

Recommended Resources

McMillan on Options, 2nd Ed.
A complete review of options and
their uses.  A 'must have' book.

Getting Started in Options
An easy-to-read guide to the
complex world of options.