Call Option

Definition:
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.

A standard U.S. equity option usually represents 100 shares. Corporate actions can produce adjusted contracts with different deliverables; check the contract multiplier and OCC adjustment terms. This page describes physically settled stock options. Cash-settled options have different settlement mechanics.

Buying Call Options

Call buying is a straightforward way of trading call options. The smaller initial outlay can produce a large percentage return on a successful trade, but the buyer can also lose the entire premium. A simple structure does not mean a low-risk investment.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares.

Say you were spot on and the price of XYZ stock rallies to $50 after the company reported strong earnings and raised its earnings guidance for the next quarter. Exercising the call and immediately selling the shares at those prices would produce a profit of $800 before costs, as the following calculation shows.

Let us take a look at how we obtain this figure.

If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a gain of $10 per share before the option premium and transaction costs. For this standard 100-share contract, the difference between the $5,000 sale proceeds and the $4,000 share purchase cost is $1,000. Exercise requires funding the share purchase or arranging the transaction with your broker.

Since you had paid $200 to purchase the call option, your net profit for the entire trade is $800. It is also interesting to note that in this scenario, the call buying strategy's ROI of 400% is very much higher than the 25% ROI achieved if you were to purchase the stock itself.

This strategy of trading call options is known as the long call strategy. See our long call strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Selling Call Options

Instead of purchasing call options, one can also sell (write) them and receive a premium. Call option writers, also known as sellers, may hope that they expire worthless so that they retain the premium without an exercise obligation. Profit is not assured: the obligation can cost more than the premium received. One can sell covered calls or naked (uncovered) calls.

Covered Calls

The short call is covered if the call option writer owns the obligated quantity of the underlying security. The covered call is a popular option strategy that enables the stockowner to generate additional income from their stock holdings thru periodic selling of call options. See our covered call strategy article for more details.

Naked (Uncovered) Calls

When the option trader writes calls without owning the obligated holding of the underlying security, he is shorting the calls naked. Naked short selling of calls is a highly risky option strategy and is not recommended for the novice trader. See our naked call article to learn more about this strategy.

Call Spreads

A call spread combines bought and sold call options on the same underlying with different strikes and/or expirations. A conventional matched vertical spread uses the same expiration and bounds the option payoff at that expiration. Calendar and diagonal spreads involve different expiration dates, so the value of the remaining option must be considered; their profit and risk cannot be read from a single common-expiration payoff line.

Call buyer and seller risk

A stock call buyer’s maximum option loss is the premium plus costs; profit has no theoretical upper bound as the stock rises. A covered call caps the stock’s upside while retaining substantial stock downside. An uncovered call seller can incur unlimited loss. Receiving a premium is not a guarantee of income or profit.

Breakeven and losing outcomes

For the $40-strike call bought for $2 per share, breakeven at expiration is $42 before costs. At $41, the option is worth $100 and the trade loses $100. At $40 or below, it expires worthless and the full $200 premium is lost. The stock can rise and the option trade can still lose money. The 400% return above is one hypothetical outcome, not an expected return; the stock and option investments commit different amounts of capital and have different risks.

Selling to close, time value and earnings

You can sell an option you own to close the position while its market is open, instead of exercising it. Selling may preserve remaining time value that exercise gives up. Before expiration, the premium depends on more than intrinsic value: time remaining and implied volatility also matter. Time decay or a fall in implied volatility after earnings can offset a favorable stock move.

The exercise right in these examples assumes an American-style contract. European-style options restrict exercise to expiration. Confirm the broker’s expiration instructions and the funding or share obligations that exercise can create.