A call gives the owner (buyer)
- the right (not the obligation)
- to buy the underlying (a given stock)
- at a given price (strike)
- before a given date (expiration date)
- In exchange, the owner of the call pays a premium to the seller.
There are a few important concepts here
Options have buyers and sellers. Each one is at the opposite site of the obligation: the buyer has a right, the seller has an obligation. It is the buyer that decides.
It is well defined what the option is about: the stock and the price are defined in the option. Once the option is bought, there is no possibility to change these parameters.
There is an expiration date: at a given point in time, the rights no longer exists. It has expired. As the buyer of the option, you need to keep this in mind.
Options are not free. You need to buy a premium to become the owner of the option. That premium is given to the seller in exchange for taking on the obligation.
Buying a call option
As a buyer, you only have rights. You have paid a premium for these rights.
You have the right to buy the stock at the strike price. You need to do this before the expiration date.
It means that you decide what happens. The only risk you take is the option premium that you pay to buy the option contract. You can never loose more than this amount.
It is your call (pun intended) to exercise your right and actually buy the stock at the strike price. You can do this anytime before the expiration date (american style options only – this is most options except on indexes like AEX, SPX,…)
Remember, on the expiration date (more on the exact timing later), you loose your rights. Would this happen, you than have paid a premium that you now loose.
Off course, when the stock trades below the strike, you will not use your right to buy at the strike. This is called out-of-the-money. You can buy the stock on the market at a price lower than the strike.
When the stock trades above the strike price, the option would be in-the-money. You can then exercise your right to buy the stock at the strike and pay less than the current market price. Or you can sell the option back and make the profit in this way. When you have a call and the stock price goes up, the value of the call goes up. (There are actually many paramaters to decide on the price of an option. This is a first one: the price of the underlying stock)
You buy a call option on stock ABC (the underlying) for a strike of 60€. Imagine that this trades for 0,5€. The option expires on May 19.
This means that you have the right to buy ABC at a price of 60€ between now and May 19. This will be on top of the premium you paid. So, you will be paying in the end 60,5€ for the stock ABC. (and the trading costs/fees off course)
Why buy a call option?
If you think that the underlying will go up, then you can buy a call option. With a limited investment – the premium – you could get great returns. Imagine stock ABC, worth now 50€. You buy an option that expires one month from now at a strike of 55€. You pay 1€ for this.
If at the end of the month the stock is worth 60€, then you just turned your 1 into 5€.
You paid 1€ for the option
You exercise your right to buy the stock for 55€. As the market price now is 60€, you could sell it and make an instant 5€ of profit. You just multiplied your investment 5€ times. Keep in mind the trading costs
Here is the caveat. The stock needs to be above 55€ before one month from now: the expiration date of this specific option. If not, the option is worth 0€ to you. Imagine the stock is at 54,5€ one month from now and then jumps to 60€ a week later. You lost your premium. You have no gain.
After the expiration date, you no longer have the right to buy the stock. You have zero rights.
Selling a call
If someone can buy a call, someone needs to sell the call. Selling a call is also known as writing an option.
When you write a call, you get upfront a premium. This premium covers the risk you take during the lifetime of the option: you have to obligation to sell a stock at a given price. When you do not have the stock in your portfolio, you need to buy the stock on the market and then sell it at the strike.
It is clear that this is a high risk! Imagine that the strike is 50€ and the stock does well and goes to 100€ during the lifetime of the option. You still have to sell it at 50€. Imagine you do not have that stock, you then need to buy it at 100€ and sell at 50€. That is a big loss. Only sell calls when you are experienced. I will come back later to this topic: there are moments when it makes sense to sell calls: as part of a strategy or when you have the stock in your portfolio and want to boost your return.