Basics of call options

If you are familiar with call options please proceed to the next lesson-Why use a covered call?

  • The Options Institute at CBOE®
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What are call options?

A call option is a contract between a buyer and a seller. In return for paying a price, known as the premium, the buyer of a call gets the right, not the obligation, to buy 100 shares of the underlying stock at a specific price until a specific date. The seller of a call option receives the premium and takes on the obligation to sell 100 shares if the buyer of the call chooses to buy them.

Why use options?

Options can help long-term investors target several investment objectives such as limiting risk, increasing income and planning ahead. In general, buying an option is a risk-limiting strategy, because the maximum risk of buying an option is the premium paid, which is only a fraction of the price of the underlying stock. Selling options is usually a strategy that has the objective of increasing income, because, if the option buyer does not exercise the right, then the option seller keeps the premium. Options can help investors plan ahead in a number of ways. For example, if a cash payment is expected in the future, such as a year-end bonus or a maturing certificate of deposit, then options can be used to plan for the investment of the anticipated funds. Also, if stock is owned with a target selling price in mind, then options can help achieve that selling price, even if the stock does not rise to the targeted level.

An option trading instruction

An option order contains more information than a stock order. For example, consider the following order: Buy to Open 1 January 21, 2014, XYZ 70 Call at 3.25

Buy Like a stock trade, this is the action (also sell)
To open

Not like a stock trade, this indicates a new position

(“to close” indicates that an existing position is being eliminated)

1 Similar to a stock trade, but different. This indicates the number of contracts that are being traded (not the number of shares)
January 21, 2014 Not like a stock trade, this is the expiration date, which is the date after which the option and the right it contains cease to exist.
XYZ Similar to a stock trade, but different. This is the “underlying,” which is usually 100 shares of XYZ stock.
70 Not like a stock trade, this is the “strike price,” which is the price at which stock is traded if an option is exercised.
Call Not like a stock trade, this is the type of option. There are also put options.
At 3.25 Like a stock, this is the price per share of the option. Since the underlying is 100 shares, the total dollar cost is $325 plus commissions.

What is a long call?

The term “long” refers to the buyer of an option who has a right. A “long call,” therefore, is simply a purchased call option with an open right to buy shares. An investor who owns a call option is described as having a “long call position,” which means that this investor has the right to buy shares in the underlying stock at the strike price of the call until the expiration date.

What is a short call?

The term “short” refers to the seller of an option who has an obligation. A “short call,” therefore, describes an open obligation to sell shares. An investor with an open obligation to sell shares is described as having a “short call position,” which means that this investor is obligated to sell shares of the underlying stock at the strike price of the call until the expiration date.

Exercising a long call

“Exercise,” in the context of options, means that an option owner is invoking the right contained in the option contract. Since owning a call – a long call – contains the right to buy the underlying stock, “exercising a long call” means that a call owner is demanding to buy the stock from the call seller. Exercise must occur prior to established deadlines on or before the expiration date. The result of exercise is that the underlying stock is purchased at the strike price of the call. Upon exercise of a call, a normal stock purchase transaction occurs. Three business days later the shares will be deposited into your account and cash to pay for the shares will be withdrawn. The amount of the cash withdrawn will be equal to the strike price times the number of shares plus the commission.

Assignment on a short call

“Assigned” means that a short option position has been chosen to fulfill the obligation contained in the option contract. Since a short call position contains the obligation to sell the underlying stock, “assigned on a short call” means that an investor with a short call position is being required to sell the stock to the owner of the call. Assignment can occur on any business before the expiration date. If assignment occurs before the expiration date, it is known as an “early exercise.” Every business day, after the market closes, The Options Clearing Corporation, the central clearing house for all listed options in the U.S., processes exercise requests and assignments. Fidelity will notify you of an assignment no later than before the opening of trading on the day after notification from The Options Clearing Corporation is received. Upon assignment of a call, a normal stock sale transaction occurs. Three business days later the shares will be withdrawn from your account and the cash to pay for the shares will be deposited.

Introduction to profit-loss diagrams

A profit-loss diagram is a tool for understanding and analyzing option strategies. When completed, a profit-loss diagram shows many things about a strategy such as profit potential, risk potential and breakeven point.

A profit-loss diagram is drawn on grid in which the horizontal axis represents a range stock prices and the vertical axis represents profit or loss on a per share basis.

Graphing stock

Even though the profit-loss diagram of purchased stock is known to most investors, it is helpful to review the basics of a stock profit-loss diagram, because the same concepts are applied to option diagrams.

Graph 1 is a diagram of “long stock.” The term “long” means that the stock was purchased. In Graph 1 it is assumed that one share of stock is purchased for $39 per share. Note that the diagram is drawn on a per-share basis and commissions are not included. Quite simply, the line depicting profit or loss from buying stock at $39 per share starts in the lower left of the profit-loss grid, where losses are incurred, and rises to the upper right, where profits are earned. It crosses the horizontal axis at the purchase price, where the strategy breaks even.

Graphing a long call

Graph 2 is a diagram of a “long call.” In Graph 2 it is assumed that a call with a strike price of 40 is purchased for 1.50 per share, or, in the language of options, “a 40 Call is purchased for 1.50.” A quick comparison of Graphs 1 and 2 shows the differences between long stock and a long call.

A long call has a maximum risk of the cost of the call, 1.50 per share in this example; and the horizontal line to the left of 40, the strike price, illustrates that the maximum risk occurs with the stock price at or below 40. To the right of 40, the profit-loss line slopes up and to the right. Losses are incurred until the long call line crosses the horizontal axis, which is the stock price at which the strategy breaks even. In this example, the breakeven stock price is 41.50, which is calculated by adding the strike price of the call to the price of the call, or 40 + 1.50. Above 41.50, or to its right on the diagram, the long call earns a profit.

Graphing a short call

Graph 3 is a diagram of a “short call.” In Graph 3 it is assumed that a call with a strike price of 40 is sold for 1.50 per share, or, in the language of options, “a 40 Call is sold for 1.50.”

The seller of a call has the obligation to sell the underlying shares of stock at the strike price of the call. Therefore, a short call has unlimited risk, because the stock price can rise indefinitely. The profit potential, however, is limited to the premium received when the call was sold.

The horizontal line to the left of 40, the strike price in this example, illustrates that the maximum profit is earned when the stock price at or below 40. To the right of 40, the profit-loss line slopes down and to the right. Profits are earned until the short call line crosses the horizontal axis, which is the stock price at which the strategy breaks even. In this example, the breakeven stock price is 41.50, which is calculated by adding the strike price of the call to the price of the call, or 40 + 1.50. Above 41.50, or to its right on the diagram, the short call incurs a loss.

Profit-loss diagrams help investors in several ways. They make it possible to visualize a strategy. They reveal important aspects of a strategy such as profit potential, risk and breakeven. They also enable comparisons to other strategies. With a little practice anyone can learn to draw profit-loss diagrams.

Key takeaways

Call Options are contracts. Buyers of calls pay a price (premium) and get the right to buy the underlying shares of stock at the strike price until the expiration date. Sellers of calls receive the premium and take on the obligation of selling the shares if the buyer exercises the right to buy.

Options can help long-term investors target several investment objectives such as limiting risk, increasing income and planning ahead, but new thinking is required.

An order to trade an option requires more information than an order to trade stock.

Profit-loss diagrams help investors visualize a strategy, revealing important aspects of a strategy such as profit potential, risk and breakeven.

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