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Calls

What Is Calls?

Call options, often simply referred to as "calls," are a type of options contract that grant the buyer the right, but not the obligation, to purchase an underlying asset at a predetermined strike price on or before a specified expiration date. As a form of derivatives, the value of a call derives from the price movements of its underlying asset. Calls are primarily used by investors who anticipate an increase in the price of the underlying asset. If the price of the underlying asset rises above the strike price, the call option gains value. Conversely, if the price falls or remains below the strike price, the call may expire worthless.

History and Origin

The concept of options has roots stretching back centuries, with unlisted, bilaterally negotiated options traded in the United States as early as the 1790s. Early options markets were often informal and lacked standardization. A significant turning point occurred in 1973 with the founding of the Chicago Board Options Exchange (CBOE). The CBOE introduced the first U.S. exchange to trade standardized, listed options, bringing centralized liquidity and a dedicated clearing entity to the market.9,8 This standardization, which included fixed strike prices and expiration dates, greatly increased the accessibility and transparency of options trading, paving the way for their widespread adoption.7

Key Takeaways

  • Call options provide the holder the right, but not the obligation, to buy an underlying asset at a specific price.
  • Buyers of calls generally expect the price of the underlying asset to increase.
  • The price paid for a call option is known as the option premium.
  • If the underlying asset's price remains below the strike price at expiration, the call option will typically expire worthless, resulting in the loss of the premium paid.
  • Call options can be used for speculation, hedging, or generating income when sold.

Formula and Calculation

While there isn't a simple algebraic formula to calculate a call option's exact premium, its price is determined by several factors, including the price of the underlying asset, the strike price, the time remaining until expiration date, interest rates, dividends, and anticipated volatility of the underlying asset. These factors are often incorporated into complex mathematical models, such as the Black-Scholes model, to derive the theoretical value of the option premium. The actual market price of a call option, however, also reflects supply and demand dynamics.

Interpreting the Calls

Interpreting call options involves understanding their relationship to the underlying asset's price relative to the strike price.

  • A call option is considered "in-the-money" when the underlying asset's current market price is above the strike price. This means the option has intrinsic value, as it would be profitable to exercise.
  • A call option is "at-the-money" when the underlying asset's price is equal or very close to the strike price.
  • A call option is "out-of-the-money" when the underlying asset's price is below the strike price. In this scenario, the option has no intrinsic value and consists solely of time value.

As the expiration date approaches, the time value of an out-of-the-money call option erodes rapidly, a phenomenon known as time decay. Traders assess whether a call option is likely to move in-the-money before expiration based on their market outlook and the factors influencing the option's premium.

Hypothetical Example

Imagine an investor believes that XYZ Corp. stock, currently trading at $50 per share, will significantly increase in value over the next two months. To capitalize on this belief with less capital than buying shares outright, they decide to purchase call options.

They buy one call option contract (representing 100 shares) with a strike price of $55 and an expiration date two months away, paying an option premium of $2.00 per share, or $200 for the entire contract (100 shares * $2.00).

Scenario 1: XYZ Corp. stock rises to $60 before expiration.
The investor's call option is now in-the-money by $5 per share ($60 current price - $55 strike price). They could choose to exercise the option, buying 100 shares at $55 each and immediately selling them at the market price of $60 for a gross profit of $500. After deducting the $200 premium paid, their net profit is $300. Alternatively, they could simply sell the call option itself, which would now be worth at least $500 (its intrinsic value) plus any remaining time value, typically realizing a similar profit.

Scenario 2: XYZ Corp. stock falls to $48 before expiration.
The investor's call option is out-of-the-money, as the $48 market price is below the $55 strike price. The option will likely expire worthless, and the investor loses the entire $200 premium paid.

Practical Applications

Call options are versatile financial instruments with several practical applications in investment and trading strategies:

  • Speculation: Investors can use calls to speculate on rising asset prices with less capital outlay compared to buying the underlying shares. This offers significant leverage, magnifying potential percentage gains from favorable price movements.
  • Hedging: While less common for individual calls, certain strategies involving calls can be used to hedge existing short positions in the underlying asset, limiting potential losses if the asset's price rises unexpectedly.
  • Income Generation: Investors can write (sell) covered calls against shares they already own to generate income from the premium received. This strategy is typically employed when the investor believes the stock price will remain flat or slightly decline.
  • Market Indicators: Aggregate data such as open interest and trading volume in call options can provide insights into market sentiment regarding an underlying asset.

Options trading in the U.S. is regulated by bodies such as the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and the Commodity Futures Trading Commission (CFTC), which work to ensure fair markets and investor protection.6, Trading options typically requires specific approval from a brokerage firm, underscoring the need for investors to understand the associated risks.5

Limitations and Criticisms

While call options offer compelling advantages, they also come with significant limitations and risks. A primary concern for call buyers is the concept of time decay, or theta. As an option approaches its expiration date, its extrinsic or time value diminishes. This means that even if the underlying asset's price moves favorably, the call option may lose value if the movement is not strong enough to offset the loss of time value, or if it happens too slowly. For out-of-the-money calls, the entire premium can be lost if the underlying asset does not reach or exceed the strike price by expiration.4

Another criticism is the complexity involved in understanding various option strategies and the multiple factors influencing an option's price, such as volatility. This complexity can lead to miscalculations or incorrect trade setups, particularly for inexperienced traders.3,2 Furthermore, for option sellers (writers of calls), the risk can be theoretically unlimited if they sell uncovered calls and the underlying asset's price rises sharply. This exposure highlights why option trading requires a thorough understanding of potential outcomes and careful risk management.1

Calls vs. Puts

The fundamental distinction between calls and put options lies in the right they convey and the market view they represent. Call options provide the holder the right to buy an underlying asset, and are typically purchased by investors who anticipate an increase in the asset's price. Conversely, put options give the holder the right to sell an underlying asset. Puts are bought by investors who expect the asset's price to decline. While calls benefit from rising prices, puts profit from falling prices. Both are types of options contracts and involve a strike price and an expiration date.

FAQs

What does it mean to "buy a call"?
When you buy a call, you are purchasing the right, but not the obligation, to buy shares of the underlying asset at a specific price (the strike price) before a certain date (the expiration date). You pay an option premium for this right.

Can I lose more than I invest in a call option?
If you buy a call option, the maximum you can lose is the premium you paid for the contract. Your potential profit, however, is theoretically unlimited if the underlying asset's price rises significantly.

What is a "covered call"?
A covered call is an options strategy where an investor sells (writes) a call option while simultaneously owning an equivalent amount of the underlying asset. For example, selling one call contract on XYZ stock requires owning 100 shares of XYZ stock. This strategy generates income from the premium received and limits the potential loss from the sold call, as you own the shares required to fulfill the obligation if the call is exercised.

How are calls related to leverage?
Call options provide leverage because a small change in the price of the underlying asset can lead to a much larger percentage change in the value of the call option. This allows investors to control a larger amount of the underlying asset with a relatively small capital outlay (the premium) compared to buying the shares outright.