Call Options Definition:
Call options are a type of security that give the owner the right to buy a lot (pre-decided quantity) of shares of a stock or an index at a certain price by a certain date. That “certain price” is called the strike price, and that “certain date” is called the expiration date. A call option is defined by the following 4 characteristics:
- There is an underlying stock or index
- There is an expiration date of the call option
- There is a strike price of the call option
- The option is either the right to buy or the right to sell (call and put, respectively)
A call option is called a “call” because the owner has the right to “call the stock away” from the seller. It is also called an “option” because the owner of the call option has the “right”, but not the “obligation”, to buy the stock at the strike price. In other words, the owner of the call option (also known as “long a call”) does not have to exercise the option and buy the stock–if buying the stock at the strike price is unprofitable, the owner of the call can just let the option expire worthless.
Since call options give the owner the right to buy a stock at a fixed price, owning calls allows you to lock in a maximum purchase price for a stock. It is a maximum purchase price because if the market price is lower than your strike price, then you would buy the stock at the lower market price and not at the higher exercise price of your option. It is called “a call option” because it allows you to “call” the stock away from somebody (ie, buy it).
Calls trade on an exchange, just like stocks do. Like all securities, all calls and puts have a unique ticker symbol and their price are determined by the market. The collection of buyer and sellers of the specific call option at any point in time determine the current prices.
Options have a bid and ask price just like stocks. But because the volume on options is much lower than the volume on stocks, the spread between the bid price and the ask price is much higher than the bid/ask spread on stocks. Whereas the bid/ask spread on stocks is usually just one or two cents, the bid/ask spread on call options and put options can be as high as 20 cents or more.
When to Buy Call Options:
If you think a stock price is going to go up, then there are 3 trades that you can make to profit from a rising stock price:
- you can buy the stock
- you can buy call options on the stock, or
- you can write put options on the stock
Call Options Example:
Suppose XYZ stock is at Rs 40 and you think XYZ’s stock price is going to go up to Rs 50 in the next few days. One way to profit from this expectation is to buy 100 shares of XYZ today at Rs 40 and sell it in a few days when it goes to Rs 50. This would cost Rs 4,000 today and when you sold the 100 shares of stock in a few days you would receive Rs 5,000 for a Rs 1,000 profit and a 25% return.
That sounds great, but watch how buying a call option on XYZ would have given you a 400% return (instead of the 25% return from buying the stock!). So a possibility of huge profit because of leverage is there , at least on paper. What is the possibility of achieving this is something needs to be seen.