When you purchase a call option you get a contract that entitles you to buy the underlying commodity or financial instrument, such as a share of stock, at a guaranteed price called the strike price. You pay a fee called a premium for the call option, and you can exercise your right to buy until the option expires. Call options have advantages that make them powerful tools for investors.
The premium for a call option costs far less than the equivalent underlying security. The resulting leverage increases the potential return on your investment. Let’s say you buy shares of XYZ Corp. at $30 per share. A few weeks later, the stock is selling for $33. You sell, netting $3 per share or a 10 percent profit. Suppose you bought a call option for the same shares with a strike price of $30 per share and pay a $1.50-per-share premium. When the price hits $33, you exercise the call option to buy the shares for $30 and then sell them for $33. You make $3 per share minus the $1.50 premium, or a net profit of $1.50 per share. That is a 100 percent profit.
Call options have a reputation for being high-risk investments, and in some ways that is true. Suppose the price of the underlying security for a call option does not rise above the strike price before the option expires. The option is worthless and you lose all the money you put up. However, the premium is the limit of your risk. If the shares you bought of XYZ Corp. described in the previous section should fall to $25 per share, you’ve lost $5 per share. With a call option, the most you lose is the premium amount, which in this example is $1.50 per share.
You can generate additional income by switching roles and selling call option contracts. When you are the seller, you are known as the option writer. Suppose you own stock that has appreciated since you bought it. You can write a call option with a strike price equal to the current market price and collect a premium. In options trading, this is referred to as a covered call. If the call option you wrote is exercised, you sell the shares you own to complete the contract. You keep the premium along with the gains you made on the stock up to the strike price. If the stock drops in price so that the option isn’t exercised, you keep the shares and the premium. The premium then offsets part of the loss from the fall in the stock price.
Trading call options allows you to employ a variety of income-enhancing and risk-reducing strategies using combinations of options and the underlying security. To illustrate, let’s look at one simple example: the bull call spread. This strategy involves two call options that are identical except for the strike price. You purchase a call option with a strike price near the market price and simultaneously write a call option at a higher strike price. The premium you collect for the call you write offsets all or part of the premium you pay for the call option you buy. This does limit the potential profit, since if the price of the underlying security rises above the strike price of the option you wrote, any further gains on the call you bought are offset by losses on the call you wrote. However, a bull call spread has the effect of reducing your up-front investment and hence your risk.