In our last explainer, about put options, we discussed how investors can use option contracts to make money when a given stock declines in value. While put options give the option holder the right to sell shares, a call option does the opposite, giving them the right to buy shares. Accordingly, investors can use call options to make money when a stock rises in value, and even more so than if they’d simply invested in it as per usual.
To quickly review, options contracts give the option holder the right to buy (in a call option) or sell (in a put option) 100 shares of an underlying security, at a predefined price (the strike price) from the option writer by a specified date. The option writer will also charge the option holder a premium for their trouble.
So, a call option lets you buy 100 shares of a stock at a predetermined price by a particular date. Why bother with this? Simple: because if that stock happens to do well, and rises in value, it may wind up being worth more than the strike price you set at the outset. By exercising the option, you can buy those shares at a discounted price, and potentially then sell them at the market rate for a profit. Accordingly, a call option is said to be “in the money” if the strike price is lower than the market price of the underlying stock. On the other hand, they expire worthless if the deadline passes and the strike price is still higher than the stock’s market price.
The perspective of the buyer
The buyer of a call option has a bullish outlook on the underlying stock: they expect it will rise above the strike price, so that exercising the option might turn them a profit (assuming, of course, it does so enough to offset the premium they paid in the first place).
That’s one way to make a profit on a call option, but it’s not the only way. Much like the stock it’s based on, the option contract itself is also a security, which has value and can be traded on the market. Say you bought a call option that expires in two months. Two weeks later, the stock it’s based on jumps in value, but not enough to exceed your option’s strike price. You’re still “out of the money,” but the option is now more likely to get there before the expiry date – which makes it more valuable. You could turn around and sell the option itself to someone else, potentially making a profit.
The perspective of the seller
On the other side of the trade, the option writer receives a premium for the call option. Since the option writer charges a premium at the outset, they stand to make a profit from the contract so long as the contract never gets “in the money.” That means they have three routes to profit, while the option holder only has one. These paths to profit are:
- The underlying’s value stays still. If the contract is called in, then the seller can simply buy the shares from the market and sell them to the contract holder for the same price, losing nothing. They still charged a premium, so they profit from the overall contract.
- The underlying’s price falls below the strike price: The seller would make a profit off of selling the shares to the option holder at the strike price, should the latter choose to exercise their option.
- The underlying’s price rises, but not by much: The seller will have to buy the shares from the market at more than the strike price. However, they’ll still have made their premium. So long as the premium value outweighs the cost of fulfilling their call obligation, the seller still comes out ahead.
Despite having a higher probability of being profitable on the option trade, the seller also takes on more risk if they are wrong. After all, there’s no limit to how high the stock’s price could rise, meaning the option seller could, in theory, be on the hook for unlimited losses.
The option seller faces three scenarios. They can get out of the contract at any time by buying the exact same option in the market for the current price, which effectively cancels-out their position. If they stay in, the outcome depends on the option holder. If the holder chooses not to exercise the option, it will eventually expire worthless, with no effect on the seller.
Because the option seller can close their position by buying back an identical option on the market, they stand to benefit if the option itself declines in value on the open market. Say the option seller sells their call for $200, and two weeks later, the value of that option declines to $50. They’re free to buy that option – earning them a profit of $150 in the process. This is called “shorting the call option.”
If the option holder does decide to exercise the call option, the seller gets assigned, and must fulfil their requirements under the contract. They must sell 100 shares of the underlying at the agreed upon price to the holder. The seller’s brokerage will perform all necessary actions for them and the individual will see the difference in their account.
Covered call strategy
In some circumstances, an investor may find it worthwhile to sell a call option even when they don’t expect the underlying stock to fall in value. Say you already hold 100 shares of a stock, which you’d like to hold onto. You expect the stock to gain value gradually over time, but you’re interested in making some money in the meantime. In this scenario, you could make a “covered call” by selling a call option on your shares, and setting the strike price at a value you doubt the stock will reach before the deadline (remember, you think it will rise, but just not that fast).
If you’re right, and the stock doesn’t rise fast enough to hit the strike price, the call option will expire worthless for the holder. You, meanwhile, will have collected the premium anyways, meaning you’ve made some money purely for the privilege of owning the stock already. You’ll then be free to turn around and repeat the strategy on those same 100 shares, if you so wish.
Of course, if you’re wrong, and the stock’s value does indeed exceed the strike price, you’ll have to sell your shares – and for a lower price than you could have otherwise. Alternatively, if the stock declines in value, you’ll take a loss, but not from the option: your existing shares will simply lose some value – but at least you got a premium for owning them in the first place.
Summary
A call option is an option contract that gives the right to buy shares of an underlying security. The option buyer wishes for the underlying to increase in value, which in turn would help their call option become more valuable. The option seller hopes the option expires worthless so that they may keep the entire premium that they received.
