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- A call option is a contract that gives you the right but not the obligation to buy a specified asset at a set price on or before a specified date.
- The cost of buying a call option is known as the premium, and it can affect your ability to turn a profit on a call option.
- Call options can enable you to mitigate risk, by limiting the amount of cash you have to invest upfront, but can also increase risk, as many options expire worthless.
When it comes to investing, many people assume that the only way to make money is to buy a stock or other asset, wait for it to go up in price, and then sell it for a profit. However, there are other ways to potentially make money through investing, without this buy-and-hold approach.
One route is to invest in options, which are contracts representing underlying assets such as stocks, as opposed to investing directly in stocks. That may sound convoluted, but options can provide flexibility and the ability to use leverage to amplify returns, although if not managed properly, the risks can be higher than investing in stocks directly.
Here, we'll dive into one specific type of option — the call option — what it is, how it works, why you might want to buy or sell it, and how a call option makes money.
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Definition of a call option
A call option is a contract that gives you the right, but not the obligation, to buy an underlying asset at a set price before a set date. For this right, you'd pay a fee, known as a premium, to compensate the option seller, who's taking the risk of having to honor the contract if the asset price moves above the call price.
Call options are also a type of derivative, and they can be traded prior to expiration, with the value fluctuating based on the likelihood of the option expiring with the underlying asset at a profitable price.
How call options work
Owning a call option contract is not the same as owning the underlying stock. Instead, a call option typically gives you the right to buy 100 shares of the underlying asset at a particular price by a particular date. For example, if a stock is currently trading at $100, you might buy a call option that gives you the right to buy the stock for $105 a year from now.
If the stock moves above $105, you might exercise your option and take advantage of the difference between the price you bought in at ($105) vs. the current price. However, the premium can eat into your profit, so the level the stock needs to rise to in order for the trade to be profitable depends on the premium for that particular option — it could be much higher than $105, depending on how much you paid for the premium.
At the same time, if the stock drops in value while you hold the call option, you're not on the hook for the loss beyond what you paid for the premium. This important trait of call options lets you hedge your bet. The option versus obligation to buy the asset lets you wait and see.
In many cases, options are traded prior to expiration. For example, if the price of the underlying asset moves in your favor prior to the expiration date, you might decide to sell the option for a profit, rather than take the risk that price later moves against you. Also, exercising the option can require a significant amount of cash, as you're generally buying 100 shares of the underlying asset. So, instead of buying that much stock, for instance, and then selling it right away for a profit, you can essentially get the same gains by selling the call option early.
Key terms for call options
Call options use special terms to refer to various components and actions of these investments, including:
- Contract: A call option is a contract between you (buyer) and the seller (writer) of the option contract. Call option contracts are typically for 100 shares of the underlying stock named in the contract. You don't have to typically sign anything, though. The contract is generally implicit, particularly when facilitated via a broker, like if you trade options through an investment app.
- Premium: This is the fee you pay to purchase a call option contract. It's a per-share amount you pay to compensate the option writer. Premiums vary based on expected volatility. Sometimes it's just a few dollars, while other times it's hundreds or even thousands of dollars. So it's not as if you can easily find a loophole to almost guarantee a profit by buying a call option for slightly above the current trading price and an expiration date way out into the future, because the premium would likely be very high. Thus, the stock price would need to increase by enough to cover the premium, not just the price you bought the option at.
- Expiration date: This is the last day the option contract is valid and it usually expires after normal market trading hours that day. If you don't buy the stock or underlying asset by then, and you don't sell the option before expiration, it expires worthless, meaning your losses are for however much you paid for the premium.
- Strike price: The strike price is the price the option seller agrees to sell or buy the underlying asset for, either on or anytime before the expiration date. For example, a call option with a $100 strike price means that the seller agrees to sell the underlying stock for $100 per share, even if the stock is trading at, say, $120. Note that options contracts generally can't be divvied up — you either have to buy all 100 shares at the strike price (so 100 shares at $100 per share, for $10,000 total in this case), sell the option prior to expiration, or let it expire worthless.
- In the money: When the current price of the underlying stock or asset is above the strike price, the contract is said to be "in the money." However, depending on the size of the premium, you might not be at a profitable level until the underlying asset price potentially moves up further.
- Out of the money: Conversely, when the current price of the underlying asset is below the strike price, the contract is said to be "out of the money." At this point, it is definitely unprofitable for a call option buyer to exercise the option, as they'd be buying the security for a higher price than if they just bought it directly. However, the option might still hold significant value prior to expiration, depending on how much time is left and how far out of the money it is.
- At the money: As you might expect, this describes a contract in which the underlying stock price and the strike price are the same.
- Exercise option: This is what you do if you decide to buy the underlying stock or asset at the strike price on or before the expiration date.
- Option chain: Investors can view all available options contracts for a specific security on the option chain, a chart that brokers or investment platforms provide and are constantly updated to show prices at various strike prices and expiration dates for different types of options.
Quick tip: Call options are tradable financial securities, just like stocks and bonds. You typically buy them from a brokerage. Most brokerages require additional account approvals to engage in options trading, as they can be riskier.
Call option vs. put option explained
There are two main types of options: call options and put options. Put options are essentially the opposite of call options. While call options give you the right but not the obligation to buy an asset at a set (strike) price on or before the expiration date, put options give you this right to sell at a particular price prior to expiration. So, you're essentially betting on the asset going down, much like shorting a stock.
Read more about put options vs. call options in our in-depth comparison.
How to use call options in trading
Call options — or any derivatives for that matter — generally are more complex than traditional securities like stocks and bonds, and thus they're typically not meant for beginners. If you do want to invest in call options though, there are a few approaches to consider:
Buying a call option
Buying a call option is often used by investors that want to try to generate a profit on a stock they're bullish on. Yet rather than investing directly in this stock, which carries the risk of substantial losses if the stock price declines, a call option only carries the risk of losing the premium.
Also, buying a call option lets you use leverage. For the price of the premium, you can invest in 100 shares of stock at a fraction of the cost. So, you don't need to put in as much cash upfront, while still potentially benefiting from price increases as if you owned 100 shares.
Still, you need to carefully consider the risk involved, namely whether the premium is worth the potential reward, as you analyze the current price, the strike price, and the expiration date. For example, would you be willing to pay $1,000 in premium if you need the stock to go up by, say, 30% in one year just to break even? If that sounds too risky, as you don't want to chance losing the $1,000 paid for the premium if you never reach the strike price, then you might prefer to just invest directly into the underlying stock, which does not have the same time constraints and potential to lose the premium.
Quick tip: Many experts suggest buying call options with an expiration date of 30 days longer than the amount of time you expect to be in the trade.
If you do decide to buy a call option, and the underlying asset appreciates in value you can:
- Exercise your option, buy the asset, sell it, and keep the profit (assuming the sale proceeds are more than the premium).
- Sell the option contract for its new higher value and keep the profit based on what you paid for the contract originally, minus the premium.
If the asset stays the same or goes down in value you can:
- Sell the option contract prior to expiration and recover at least part of the premium you paid.
- Let the option expire worthless and lose the entire premium.
Selling (writing) a call option
Another way to get involved in call options is to write your own, meaning you sell a new contract to another buyer. This can be done fairly easily through many brokerages — it's not as if you have to actually write up a contract.
Selling a call option means you collect the premium the buyer pays. No matter what, that money is yours. However, selling a call option means you're obligated to sell the underlying asset (e.g., 100 shares of stock) at the strike price on or before the expiration date if exercised. So, that can create new risks.
There are two main types of written call options — naked and covered.
Naked call option
This is when you write a call option for underlying assets you don't own. In this case, you'd write an option for a stock you think will not increase in price before the expiration date you set. A buyer thinks otherwise and pays you a premium for the contract you wrote.
If the value of the asset increases and you have to sell the buyer 100 shares at the strike price, you lose the difference between the strike price and the amount you have to pay for the shares, minus the premium. This can introduce theoretically unlimited risk.
For example, if you sell a naked call option with a strike price of $100, and the stock rises to $200, you'd be on the hook to buy 100 shares at $200 ($20,000) and sell them to the call option buyer at $100 per share ($10,000) total. So even if you collected a $1,000 premium, for example, you'd still lose $9,000 in this case. Because of this risk, many brokers do not let retail investors write naked call options.
When it comes to selling call options, Alexander Voigt, Founder and CEO of daytradingz, offers the following caveats: "Investors are often tempted to trade the so-called naked options because it appears attractive to collect the options premium. However, selling options without limiting the risk by hedging the options trade involves unlimited risk."
"Unforeseen overnight price gaps caused by news catalysts like earnings announcements involve the highest risk," he continues. "In addition, investors must be aware that the buyer of the call option has the right to demand the underlying stock at the strike price from the option seller prior to expiration."
Covered call option
A less risky way to write calls — and one that many brokers allow — is to sell a covered call, meaning an option for an asset that you already own enough of to cover the option contract. For example, if you want to write a covered call for XYZ Company, you need to own at least 100 shares of XYZ Company stock. This dramatically reduces risk compared to a naked call, because any losses on the option side are offset by gains in the underlying stock you own.
With covered calls, your motivation is often the same as it would be with writing naked call options: You believe your asset will stay the same or decline by the expiration date, so you sell the option to get the premium. But it's also possible that you want to set a price at which you'd like to exit the stock.
If the asset does not reach the strike price, you still profit from the premium, and that might help offset any loss in value of the underlying asset you also own. If the asset rises in value above the strike price, you'll need to hand it over to the buyer for the strike price. This could mean missing potential gains you would have had if you still owned the asset, but you at least get to keep the premium.
For example, suppose you write a covered call for XYZ Company with a strike price of $110, and it's currently trading at $100. If the stock moves up to $120 and the call buyer exercises, instead of losing $1,000 (aside from the premium) on the difference between the strike price and current price ($110 vs. $120), you would essentially be selling your 100 shares for $110. That means that you still gain $1,000 from the stock moving from $100 to $110, but you're missing out on another $1,000 gain if you held the stock as it went to $120. Still, you get the premium from the covered call to offset this missed gain.
As you can see, the math can get a little tricky though, which is why options aren't something to rush into without careful consideration and often the guidance of a professional, such as a financial advisor.
Protective call strategy
One of the more advanced call option trading strategies is a protective call strategy. This involves buying a call option as a way to hedge your short position on the underlying asset. If the stock ends up gaining value, gains from your call option can offset losses from your short position. This effectively turns your call option into a stop-loss instrument for your short position. Yet if the stock drops in value, you can potentially profit from your short while only losing the premium from the call option.
That said, you need to carefully consider the premium and strike price to see how that affects your short exposure. Call options are generally meant for more advanced investors, and when you start layering in more nuanced approaches like a protective call strategy, then you want to be even more sure that you know what you're getting yourself into.
Risks and rewards of trading call options
Trading call options carry the potential to increase your returns, but they also carry significant risk. If buying call options, you can potentially gain more profit than if you invested the same amount in the underlying stock, due to the power of leverage. Yet there's a risk of losing your entire premium, whereas with directly investing in stocks, you can hold through volatility and don't face the ticking clock of an options expiration date.
With writing/selling call options, you can benefit from earning a little extra income from the premium without selling your underlying stock, unless the call option buyer exercises. You can also set an exit price for yourself in a way. If you're just about ready to sell a stock, you might write an option with a strike price slightly above the current price. Then, if the stock moves above the strike price, you might not mind having to sell your shares, as you would have done so anyway, yet now you've gained extra income from the premium plus a little bit of stock price appreciation.
However, the risk is that you're still holding the underlying stock, so if it drops in value, your portfolio would lose money. And if you want to sell the underlying stock before the option expires, you typically need to close out the option by buying it back before expiration, otherwise your option would become naked, which many brokers do not allow. So, that could mean losing some of your premium or potentially even paying more, depending on the underlying asset price at that time.
There's also a risk that you could miss on potential gains by writing covered calls, as you might not be able to fully participate in underlying stock price gains if you have to sell at a lower strike price. And naked call options are even riskier, as there's no limit to how much you can lose if the asset price moves above the strike price.
Factors affecting call option prices
Call option prices vary significantly among different securities and particular options for a given security. Some factors include:
Volatility
The volatility of the underlying asset affects option prices, as a stock that has big swings might be more likely to hit a strike price than a more stable stock. For example, if a company has an earnings release coming up, call options for around that expiration date might be priced higher than normal if investors expect the earnings to cause a big shift in the underlying stock price.
Time decay
Time decay, also called theta, has a big impact on option pricing, as the closer it gets to expiration, the less likelihood typically for the underlying asset price to move significantly. For example, it's often more likely that a stock currently trading at $50 will move to $51 within a year vs. one week, given that there's more time for positive news to drive the stock up. So, all else being equal, call options typically lose value at a faster rate the closer it gets to the expiration date — especially in the last few days or weeks of the option.
Interest rates
From a macro perspective, interest rates also affect call option prices. For example, when interest rates are high, that encourages investors to hold onto more cash or cash-like instruments to earn safe returns. So, that tends to lead to higher call option prices, because investing in options and gaining leverage requires less cash than buying, say, 100 shares of underlying stock.
Dividends
Dividends can also affect option prices. For one, holding options does not entitle you to the dividends of these underlying stocks, so there's an opportunity cost there that can lower the price of options. Also, dividends generally cause stock prices to drop by a corresponding amount. So, a high-dividend stock might have lower premiums than a stock with lower dividends, as dividends can make it harder to reach the strike price.
How to evaluate when to buy a call option
As mentioned above, buying a call option isn't something you should rush into without carefully considering the risk and understanding of what you're getting into. In terms of making the actual decision, consider factors such as:
Investor goals
A big part of the decision depends on your specific goals. For example, if you're trying to limit how much cash you outlay, and you're willing to take the risk of losing premiums, you might be more inclined to buy call options vs. underlying stocks.
Another goal might be to minimize taxes. So, a somewhat complex yet often effective approach is to use options as a way to reduce capital gains exposure. For example, instead of realizing the gains from a short sale, you might buy a call option so that you can hold onto the short for longer while limiting downside risk and potentially deferring gains. Although gains from options are taxable, nothing is reported when buying call options until the option is exercised, sold, or expires. However, premiums from writing call options are taxable as ordinary income at the time of the initial sale.
Market sentiment
Market sentiment also plays a big role in evaluating when to buy a call option. Volatility is generally priced into options, but if you're more optimistic about the potential for price increases than the general market, that might encourage you to buy calls. Conversely, if the market expects big price swings, the premiums might be too high for you to feel that buying a call is worth it.
Liquidity also makes a difference. If there's not much demand for a particular stock, for example, its options might be hard to buy and sell, so that can affect pricing and your ability to exit before expiration.
How to evaluate when to sell a call option
There are two meanings to selling a call option. One involves writing a new option, which you might do if you want to earn some income while holding the underlying stock, such as if you don't think it will gain much anytime soon.
The other meaning involves how if you own a call option there are three things you can do with it. Let it "expire worthless" and lose the premium you paid (although that's all you lose); exercise your option to buy the underlying asset so you can ideally sell it for a profit; or sell the option before it expires. If selling before expiration, you might lose money if the underlying asset price is down or if there's been significant time decay, but you might make money if the underlying has gone up, even if it's not at the strike price yet.
Quick tip: Most people believe the vast majority of options "expire worthless." This is not true. According to the Options Clearing Corporation (OCC), 72% of options are closed (sold) prior to expiration, 6% are exercised, and the remaining 22% "expire."
Here are some of the reasons you may want to sell/close your call option before expiration:
- Make a profit: Over time, the underlying asset may rise in price which will, in turn, raise the premium (the fee the seller would receive). You may choose to sell your option and pocket the profit from the increased fee you would receive.
- Minimize loss: If the underlying asset remains steady or declines, you may decide to sell to recover at least part of your premium before the option expires worthless.
- Avoid having to buy the underlying asset: Even if you believe a stock will expire in the money, it might not be worth it to have to front the money to buy 100 shares of that stock when exercising, as opposed to just selling the option for a potential gain. Pay attention to commissions and transaction fees too when evaluating this issue.
- Avoid risk of spillage: Spillage happens when you exercise your option, try to sell the underlying asset on the market, and don't get what you expect, such as because of limited liquidity or if the asset price quickly moves against you.
FAQs about call options
A call option is a contract that gives the buyer the right — but not the obligation — to buy an asset at a particular price by a particular date.
A call option gives you the right to buy an asset at a particular price by a particular date, while a put option gives you the right to sell an asset at a particular price by a particular date. A call means you're essentially betting on the price rising, and a put is betting on the price falling.
The best time to buy call options depends on the investor's goals and market conditions. There's no one right answer, and it's important to carefully consider risks before investing.
If your call option expires in the money and you haven't sold it, many brokers automatically exercise the option for you, meaning you have to buy the underlying assets at the strike price. Some brokers, however, will settle the transaction on a cash basis, giving you the profit between the current price and the strike price, instead of having to purchase the shares.
