Roger Wohlner is a writer and financial advisor with over 20 years of financial services experience. He writes about financial planning for Wealthsimple and for a number of financial advisors. His work has been published in Investopedia, Yahoo! Finance, The Motley Fool, Money.com, US News among other publications. Roger owns his own finance blog called 'The Chicago Financial Planner'. He holds an MBA from Marquette University and a Bachelor’s degree with an emphasis on finance from the University of Wisconsin-Oshkosh.
A call option provides the owner of the option the right, but not the obligation, to buy a fixed number of shares of a stock at a specified price by a specified date. Call options are “written” (or created) by investors who may or may not own the underlying shares of the stock. One call option generally covers these rights to 100 shares of the stock.
Call options can be bought and sold separately from the shares of the underlying stock. They will trade at a give price for the option based on the supply and demand for the option. For example, if the price of the stock is rising, and the call option offers the opportunity to buy the shares at a “strike price” that’s significantly lower, investors will likely see the call option as more valuable than the stock price.
Options are a derivative security. The option is derived from, or based on, the underlying stock. Options are traded separately on exchanges and will have their own valuation based on several factors including the underlying price of the underlying shares and the time remaining until the expiration of the options.Wealthsimple offers an automated way to grow your money like the world's most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.
Call options are also used in a number of other settings.
Very closely related to call options on stocks are call options on ETFs, exchange traded funds that are like mutual funds that are traded each day on the stock exchange in the same way as individual stocks.
Call options are also available on some bonds and some types of commodities. In all cases, a call option is a bet that underlying price of the security in question will rise within the period of time prior to the expiration of the option.
Types of call options
Call options can have a number of uses for investors. For example, the owner of a stock may create and sell a call option that covers some or all of the shares they own. This is known as a covered call option. The owner of the shares will use their shares to cover or deliver the shares to the option holder if the option is exercised.
Why might an investor write a call option on shares they own? There could be a few reasons. Selling the option will create additional income for them related to the price received from the option buyer. In addition, they may have a nice profit on the underlying stock position and would feel comfortable selling the shares. Options at their core were invented as a hedging strategy. Perhaps the writer of the call option feels that price of the underlying shares of the stock will decline in value, at least over the near term. They might sell a series of call options over time as a way to generate additional income on their shares. The shares may be sold away from them at some point via the exercise of the options or they may expire worthless to the option buyer. In this case the owner of the shares can generate extra income by continuing to write new call options against the shares.
Options can also be written on shares that the writer doesn’t own. This is called a naked call option. What this means is that the option writer will receive a premium on the price paid for the option when they sell it. However, because they do not own the equivalent number of shares of the underlying stock, they must go into the market and purchase the shares needed to cover the option if exercised. This creates a situation where the option writer has almost unlimited liability as they are obligated to deliver these shares no matter what the cost is to them.
Buying and selling call options
Investors who want to trade options will typically need to open an options trading account with a brokerage firm. Most of the large discount brokers offer these accounts, as do more traditional brokerage firms.
Opening an account to trade options is usually a bit more involved than simply opening a regular brokerage account. Brokerage firms will screen those looking to trade options for issues such as their investing experience with options and other types of financial instruments, their financial information including their liquid net worth, their investing objectives both in general and specifically with regard to options trading and other information. Since options trading is considered to be riskier than many other forms of investing, the brokerage firms are looking to protect themselves from legal liability in the event that an inexperienced trader were to suffer significant losses from trading options.
Call versus put options
As discussed above, a call option provides the option holder the right, but not the obligation to buy the underlying number of shares, usually 100 shares, covered by the call option. Investors buy call options in the hope that the price of the underlying shares of stock will rise in value to a level above the strike price, allowing them to purchase the shares at a price that is below the market price. In other words, buyers of call options buy them in the belief that the shares of the underlying stock will rise.
A put option works in the opposite way. A put option provides the option holder with the right, but not the obligation, to sell a specified number of shares of a stock at specified price within a specified period of time. In this case, the strike price is the price at which the stock can be sold.
The writer of a put option will generally write the put to generate income on a position they already own. A put writer might also write a put option to satisfy a desire to purchase shares of stock at a price lower than the current market price of the stock.
A buyer of a put option is making a bet that the price of the underlying shares will decline in value. A put buyer who owns a put to sell shares of a price of say $40 per share back to the writer of the option makes out if the price were to fall below that level—say, to $32 per share. In this case, if the put buyer owns the shares they can sell them for $8 per share more than they are worth if traded on the open market.
Just as with call options, put options have their own value. The price received by the option is called a premium and represents a source of profit and cash flow for the option writer. Put options can be very risky as you are essentially betting the price will decline.
Risks of call options
As a derivative security, call options carry a number of risks. Among these are:
The option can expire with a worthless value. Say you buy a call option that gives you the right to purchase 100 shares of a stock at $50 per share. If the price of the underlying never reaches $50 per share, the option will expire worthless.
If you write a naked call option there is the risk that you will have to go into the market and purchase enough shares of stock at a price that is much higher than the option’s strike price to cover the exercise of the option.
If you write a covered call, your risk is that you will have to surrender the shares. Your hope in writing the call option is to have the price of your shares increase to a level that is higher than the strike price so you can profit from this share price appreciation and pocket the premium from writing the option.
Options trading can be very lucrative and very risky. For those understand what they are doing it can lead to very solid profits. For those who undertake this lightly, it can lead to risks and losses for the inexperienced options trader.
Options trading is a sophisticated hedging strategy, both calls and puts. Institutions and corporations use options to hedge their positions, to limit losses and to generate additional income from existing positions.
Call options may or may not be right for you. Beyond using them directly, there are mutual funds and ETFs that employ option strategies as part of their investing strategy that offer many of the benefits and professional management of your investment.
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