What is a Call Option?

Monday, 17 November 2008 21:26

A call option is a financial instrument known as a derivative, and is traded just like a stock. It is a contract between the buyer and the seller of the call option, that gives the buyer the right (the option if you will) to buy a certain stock at a specific price on or before a certain date.

But why would I buy a call option instead of a stock? Because using call options can give you substantially larger returns.

Let's use an example.

On Jan 10th 2008, General Electric stock (Symbol GE) is trading at $35.00.

A Feb 2008 $37.50 call option for GE is trading at $0.30. Buying a $37.50 call option will give you the buyer the right to buy GE for $37.50 on or before the call option expiration date.

If GE share prices raises to say $39.00 before the call option expires, you STILL get to buy GE for $37.50, which means that get to buy a $39.00 stock for $37.50 (your actual cost though is $37.50 + $0.30 you paid for the call option, so $37.80), and then if you wish, immediately sell the stock for a profit. So, for the price of a $0.30 call option, you made a profit of $1.20 ($39.00 - $37.80), or 400%.

Now, of course, this is just a theoretical example, but it IS possible. It's also possible that the stock price never reaches or exceeds $37.50 before the call option expires, which means the call option expires worthless, and you lose your whole investment ($0.30). In fact, it's estimated that 80% of all call options expire worthless! That's why BUYING call options is, in my opinion, a higher risk strategy for speculators. SELLING call options against stock you already own, is in my opinion, a great conservative strategy for generating additional returns. Selling call options against a stock you already own is known as the Covered Call strategy, and I highly recommend it and use it frequently. In fact 70% of my trades are selling call options against stock I already own.

I'll explain the Covered Call strategy in much more detail in my next article, but before you read about Covered Calls, you need to know the basics of call options.

Call Option Basics

Strike price	The Strike price is the price that the buyer has the right to buy the stock for if he/she chooses to. In the example above, the Strike price was $37.50.
Expiration date	The Expiration date is the date that the call option expires. It is usually selected by month, but in the case of expiration dates over 1 year, can be selected by month and year. In the example above, the expiration date was February. The exact expiration date is the third Friday of the month, so for a Nov 2008 call option, the actual expiration date is Nov 21st 2008, and for a Mar 2009 call option, the actual expiration date is Mar 20th 2009. The time of expiration is 4:00pm EDT (when the stock market closes).
Premium	The actual price of a call option is known as the Premium. In the example above, the premium was $0.30.
Exercise	If the stock price is greater than the strike price of a call option on or before it's expiration date you can buy the stock price for the strike price by Exercising the call option. The way you would do this BEFORE expiration date is to call your broker (whether that be E-Trade, Schwab, etc) and request the call option be exercised, which usually would happen within 10 minutes of the phone call. At 4:00pm EDT on the expiration date, if the stock price is greater than strike price by at least $0.05 the call option will be exercised automatically, and you will notice the stock in your brokerage account over the weekend (you'll also notice your cash balance reduced by the cost of buying the stock at the strike price) . If for some reason you do not want the call option automatically exercised, you can call your broker and request the call options not be exercised. You may do this if you haven't got enough funds in your brokerage account to buy the stock, or if you think that the stock will go down the following Monday morning (the first chance you would get to sell the stock). I have personally only done this once, for the latter reason.
Contract size	Each call option is priced per share (from the example above $0.30), however each call option is in 100 share lots, so buying 1 call option at $0.30 really means you're buying the right to buy 100 shares of the stock, and therefore you're paying $0.30 x 100 = $30.00 for the call option. Buying 5 contracts at $1.00 means you're paying $1.00 x 500 = $500.00.
Style	Call options come in 2 styles; American and European. European style call options are sold on European exchanges, while American style options are sold in North American exchanges. The difference between the 2 styles is really quite simple. European options can only be exercised on the option's expiration day. American options can be exercised at any time during the option's life.
At the money or ATM	When the strike price of the call option is the same price as the stock, the call option is said to be "at the money" (ATM).
Out of the money or OTM	When the strike price of the call option is greater than the price of the stock, the call option is said to be "out of the money" (OTM).
In the money or ITM	When the strike price of the call option is less than the price of the stock, the call option is said to be "in the money" (ITM).
Open interest or Open int	If you want to know how many people have bought a certain call option, you would look at the Open Interest. This is how many call options have been bought.
Volume or Vol	If you want to know how many people have bought a certain call option on THAT day, you would look at the Volume.
Bid	The Bid price of a call option is the price someone is willing to buy the call option for, so in other words, the Bid price is the price you can sell a call option for.
Ask	The Ask price of a call option is the price someone is willing to sell the call option for, so in other words, the Ask price is the price you can buy a call option for.
Bid/Ask spread	This difference between the Bid price and the Ask price is known as the Bid/Ask spread. You will notice that there could be a considerable difference between the Bid and Ask price, especially when compared to most stocks. The reason for this is that call options are bought and sold by far fewer people and in much smaller quantities, and thus have substantially less volume than the call options underlying stock. For example, GE's average daily stock volume is 117 million, one of GE's call options may have volume of 100 in any given day. As a result, people may not find buyers for call options they are selling at a certain price, and vice versa.
Option chain	An Option chain is a list of available options for a given stock.

Now that you have read the basics, you may be interested to see the most recent option pricing on a stock such as GE before reading my next article. You can do so by clicking GE's Option Chain. Note: pay particular attention to the call option ask and bid prices for the different strike prices.

My next article is on What is a Covered Call?.

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