Call Options Explained
You’ve figured out buying and selling stocks, fixed income investments and exchange-traded funds and are ready to take on more. What’s next? One possibility is options — specifically call options.
What is a call option?
A call option is a contract that entitles the owner the right, but not the obligation, to buy a stock, bond, commodity or other asset at set price before a set date. The owner can either exercise the contract or allow it to expire, hence the term “option.” Options themselves are not a true security but rather a type of financial derivative, in that the value is derived from that of another asset. They can be bought and sold like stocks on derivatives exchanges and over the counter by financial institutions. They do not carry the rights and benefits of owning the underlying stock, such as eligibility to receive dividends or vote on company resolutions.
Why would I want to trade options?
For the seller, writing a call option offers a potential source of revenue. A buyer pays them a price, known as a premium, for the option. (The premium is expressed on a per-share basis, though options typically cover batches of 100 shares.) For the buyer, it might be a means to further leverage their position or manage risk.
How do call options work?
Imagine an investor thinks a company could be the target of a takeover bid that would cause its share price to jump. Instead of buying shares, for the same amount of money the investor could buy a greater number of options, which would allow them to purchase the stock sometime in the future, but at today's price. If the takeover happens in that time frame and the price goes up, the investor could exercise the options and buy the shares knowing that they could be sold immediately at a higher price. (In some cases, the investor may need to borrow money to exercise their options.)
Now imagine the investor is 75% convinced shares in Company X will fall after the release of its next quarterly financial statement. They can sell their shares now and buy a call option to re-purchase an equal number of Company X shares in case they were wrong and the results surprise on the upside. This might seem complex and even inefficient for an individual investor, but such derivatives help manage risk for hedge funds and other institutional investors that take big, leveraged bets on small price differences between assets.
Long vs. short call
A long call strategy involves writing a call option for stocks or other assets already in your possession. Known as a “covered call,” this tactic involves the risk of potentially having to part with your shares if a buyer chooses to exercise their option. This will happen if the stock rises above the set "strike price" before the expiration date. Fund managers sometimes use a long call strategy to generate an income from stocks or commodities that don’t otherwise pay dividends.
In a short call, the writer (or seller) does not own the shares. They are making an uncovered or “naked call.” This is a riskier move with potentially unlimited liability should the stock rise and the writer is forced to buy the shares to fulfill their part of the contract. If the stock drops, the buyer will not exercise the option and the writer profits from the premium paid for the option.
Stock options issued to executives or other employees of a company to encourage loyalty and better job performance are a form of call option, too, though they are not publicly traded or transferable.
These are just a few examples of call option strategies. There are many more. Part of the appeal of trading options is that it is a market-neutral activity: You can generate a return in both rising and falling markets. While the buyer of a call option is betting on growth, the seller or writer is in effect taking a short position, betting the stock will fall or at least fail to surpass the price at which the option can be exercised, known as the strike price.
How options are valued
Until the call option expires, it has a value. For example, if the strike price is $50 and the stock is trading for $55, its intrinsic value is $5. If exercised immediately, the holder will have profited $5 per share minus the premium they paid for the option. If the stock is trading below the strike price, the option is “out of the money” and its value will be negligible, based only on the remaining duration of the option and the odds the stock surpasses the strike price in that time frame.
Short-term options of less than a year are typically written in anticipation of an event that could affect the stock’s price. Long-term options of more than a year are more often used to speculate on a stock’s growth. They tend to come at a higher premium owing to the longer period the stock has to exceed the strike price. The intrinsic value plus the duration of the option equals the extrinsic value reflected in the premium.
Key factors to consider when…
Buying a call option: Does the potential upside justify the premium you are paying?
Selling a call option: You bought the option for a reason. Has that reason diminished? Is the buyer willing to pay a higher premium than you paid?
How to access options trading
In order to buy and sell call options, you must have a particular kind of brokerage account.
Existing TD Direct Investing clients can apply for approval to trade options. There are four options trading levels available, according to the type of account. Approval is tied to the client’s investing knowledge, income, and account size.
Call options are usually bought and sold in blocks corresponding to the right to buy 100 underlying shares. Options sold on exchanges are generally restricted to stocks in the top quartile by market capitalization.
On a final note
Options and option strategies can be complex and are not for every investor. However, if you’ve mastered trading stocks and want to explore further opportunities available in the stock market, they may be worth checking out.
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