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.
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?