Options Article

What is a call option?

Last Updated: September 30, 2020

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This is a good generic question - so I'll expand a bit on it.

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What is a call option?

Calls are a type of option that are used to take advantage of a general rise in the market. The buyer or holder of a call has a bullish outlook, believing that the market is rising. The option affords the buyer control of 100 shares of stock and the opportunity to buy the stock at a price that is below the current market price of the underlying stock in the event that their bullish outlook is proven correct.

From the perspective of the buyer, a call is “in-the-money” when the market price of the stock is above the exercise price (strike price) of the option. For example, an AAPL 70 call is considered in-the-money when AAPL shares are trading at $70.01 a share or higher.

Calls that are written (sold) are done so as a way to profit from a fall in market prices for a person who has a bearish outlook of the market or looking to hedge/create income on an existing position in their portfolio.

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What About Loss?

Since the holder of the call has a right to exercise the contract any time up to expiration date and buy the stock at the exercise price, presumably exercise will not take place when the stock price is below the exercise price. The writer receives the premium as her profit as the price falls or alleviates losses against their stock position by keeping the premium sold.

However, this doesn’t come free. The maximum loss in this position is unlimited if the call is sold without the underlying stock in the portfolio. In the event of exercise from the buyer of the option, the seller will have to go into the market and purchase it at whatever prices the shares are available in the market and deliver them to the buyer of the call option sold.

Other Call Option Strategies

There are other ways that call options are used as part of neutral market strategies, such as a long call calendar spreadCovered writing, where a call is written against an existing position in the stock. Such a strategy provides a hedge against loss in a bear market. The premium received acts as insurance against the loss in value, since exercise will require delivering the stock at the strike price, which is typically (but not always) less than the price paid for the stock.

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The above graph shows the payoff for owning call options with a strike price of $40 and a cost of $2. According to the graph, if the stock price is near or below the $40, there will be loss of $200. The stock price increases above $40, the line slopes up indicating your profit. The up sloping line become profitable at $42, which is the strike price of $40 plus the $2 cost of buying the option.

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