What Is a Call Option and How to Use It With Example

What Is a Call Option?

Call options are financial contracts that give the option buyer the right but not the obligation to buy a stock, bond, commodity, or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer profits when the underlying asset increases in price.

A call option may be contrasted with a put option, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.

Understanding Call Options

Let's assume the underlying asset is stock. Call options give the holder the right to buy 100 shares of a company at a specific price, known as the strike price (exercise price), up until a specified date, known as the expiration date.

For example, a single call option contract may give a holder the right to buy 100 shares of Apple stock at $100 up until the expiration date three months later. There are many expiration dates and strike prices that traders can choose. As the value of Apple stock goes up, the price of the option contract goes up, and vice versa. The call option buyer may hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock, or they can sell the options contract at any point before the expiration date at the market price of the contract at that time.

You pay a fee to purchase a call option, called the premium. It is the price paid for the rights that the call option provides. If at expiration the underlying asset is below the strike price, the call buyer loses the premium paid. This is the maximum loss.

For example, if Apple is trading at $110 at expiry, the option contract strike price is $100, and the options cost the buyer $2 per share, the profit is $110 - ($100 +$2) = $8. If the buyer bought one options contract, their profit equates to $800 ($8 x 100 shares); the profit would be $1,600 if they bought two contracts ($8 x 200).

Now, if at expiration Apple is trading below $100, obviously the buyer won't exercise the option to buy the shares at $100 apiece, and the option expires worthless. The buyer loses $2 per share, or $200, for each contract they bought—but that's all. That's the beauty of options: You're only out the premium if you decide not to play.

Long vs. Short Call Options

There are two basic ways to trade call options.

• Long call option: A long call option is, simply, your standard call option in which the buyer has the right, but not the obligation, to buy a stock at a strike price in the future. The advantage of a long call is that it allows you to plan ahead to purchase a stock at a cheaper price. For example, you might purchase a long call option in anticipation of a newsworthy event, say a company's earnings call. While the profits on a long call option may be unlimited, the losses are limited to premiums. Thus, even if the company does not report a positive earnings beat (or one that does not meet market expectations) and the price of its shares declines, the maximum losses that the buyer of a call option will bear are limited to the premiums paid for the option.
• Short call option: As its name indicates, a short call option is the opposite of a long call option. In a short call option, the seller promises to sell their shares at a fixed strike price in the future. Short call options are mainly used for covered calls by the option seller, or call options in which the seller already owns the underlying stock for their options. The call helps contain the losses that they might suffer if the trade does not go their way. For example, their losses would multiply if the call were uncovered (i.e., they did not own the underlying stock for their option) and the stock appreciated significantly in price.

How to Calculate Call Option Payoffs

Call option payoff refers to the profit or loss that an option buyer or seller makes from a trade. Remember that there are three key variables to consider when evaluating call options: strike price, expiration date, and premium. These variables calculate payoffs generated from call options. There are two cases of call option payoffs.

Payoffs for Call Option Buyers

Suppose you purchase a call option for company ABC for a premium of $2. The option's strike price is $50, and it has an expiration date of Nov. 30. You will break even on your investment if ABC's stock price reaches $52—meaning the sum of the premium paid plus the stock's purchase price. Any increase above that amount is considered a profit. Thus, the payoff when ABC's share price increases in value is unlimited.

What happens when ABC's share price declines below $50 by Nov. 30? Since your options contract is a right, and not an obligation, to purchase ABC shares, you can choose to not exercise it, meaning you will not buy ABC's shares. Your losses, in this case, will be limited to the premium you paid for the option.

Payoff = spot price - strike price

Profit = payoff - premium paid

Using the formula above, your profit is $3 if ABC's spot price is $55 on Nov. 30.

Payoff for Call Option Sellers

The payoff calculations for the seller for a call option are not very different. If you sell an ABC options contract with the same strike price and expiration date, you stand to gain only if the price declines. Depending on whether your call is covered or naked, your losses could be limited or unlimited. The latter case occurs when you are forced to purchase the underlying stock at spot prices (or, perhaps, even more) if the options buyer exercises the contract. Your sole source of income (and profits) in this case is limited to the premium you collect on expiration of the options contract.

The formulas for calculating payoffs and profits are as follows:

Payoff = spot price - strike price

Profit = payoff + premium

Using the formula above, your income is $1 if ABC's spot price is $47 on Nov. 30.

Uses of Call Options

Call options often serve three primary purposes: income generation, speculation, and tax management.

Using Covered Calls for Income

Some investors use call options to generate income through a covered call strategy. This strategy involves owning an underlying stock while at the same time writing a call option, or giving someone else the right to buy your stock. The investor collects the option premium and hopes the option expires worthless (below strike price). This strategy generates additional income for the investor but can also limit profit potential if the underlying stock price rises sharply.

Covered calls work because if the stock rises above the strike price, the option buyer will exercise their right to buy the stock at the lower strike price. This means the option writer doesn't profit from the stock's movement above the strike price. The options writer's maximum profit on the option is the premium received.

Using Calls for Speculation

Options contracts give buyers the opportunity to obtain significant exposure to a stock for a relatively small price. Used in isolation, they can provide significant gains if a stock rises. But they can also result in a 100% loss of the premium if the call option expires worthless due to the underlying stock price failing to move above the strike price. The benefit of buying call options is that risk is always capped at the premium paid for the option.

Investors may also buy and sell different call options simultaneously, creating a call spread. These will cap both the potential profit and loss from the strategy but are more cost-effective in some cases than a single call option because the premium collected from one option's sale offsets the premium paid for the other.

Using Options for Tax Management

Investors sometimes use options to change portfolio allocations without actually buying or selling the underlying security.

For example, an investor may own 100 shares of XYZ stock and may be liable for a large unrealized capital gain. Not wanting to trigger a taxable event, shareholders may use options to reduce the exposure to the underlying security without actually selling it. In the case above, the only cost to the shareholder for engaging in this strategy is the cost of the options contract itself.

Example of a Call Option

Suppose that Microsoft stock is trading at $108 per share. You own 100 shares of the stock and want to generate an income above and beyond the stock's dividend. You also believe that shares are unlikely to rise above $115 per share over the next month.

You take a look at the call options for the following month and see that there's a 115 call trading at 37 cents per contract. So, you sell one call option and collect the $37 premium (37 cents x 100 shares), representing a roughly 4% annualized income.

If the stock rises above $115, the option buyer will exercise the option, and you will have to deliver the 100 shares of stock at $115 per share. You still generated a profit of $7 per share, but you will have missed out on any upside above $115. If the stock doesn't rise above $115, you keep the shares and the $37 in premium income.

The Bottom Line

Call options are financial contracts that give the option buyer the right but not the obligation to buy a stock, bond, commodity, or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. Options can be speculative instruments that rely on leverage. A call buyer profits when the underlying asset increases in price. A call option seller can generate income by collecting premiums from the sale of options contracts. The tax treatment for call options varies based on the strategy and type of call options that generate profits.