Definition: A call option represents a contractual agreement between a buyer (holder) and seller (writer). The buyer of the call has the right to buy an underlying asset at a specified price (strike price) and quantity for a fixed period of time (expiration).
The seller of the call has the obligation to sell the underlying asset at the specified price and quantity, if the option can be exercised before the expiration date. By taking on the obligation and risk of delivering the underlying asset to the call holder, the seller is paid a premium.
For stock options, each call option covers 100 shares.
Buying Call Options
Traders buy call options when they are bullish on a stock (long calls). Let’s take a look at an example to help you understand the basic concept of buying a call option.
Stock ABC is trading at $25. You purchase a call option with two months to expire with a strike price of $25 for $1 ($100 because each option covers 100 shares). Two months go buy and the stock is trading at $30. Since you have the right to exercise your option, you are able to buy 100 shares of the stock at $25 and sell it at the current price of $30. This trade results in a profit of $400 ($500 for price difference - $100 option premium).
If the stock goes down to $22 over those two months, the buyer of the option losses out on the $100 spent to acquire the call option.
Selling Call Options
Traders can take the opposite side of the trade and sell (write) the call option. In this case, the trader hopes that the option expires worthless by the expiration date and they profit from selling the premium. A trader can sell covered calls or naked calls.
Selling covered calls, means the trader owns the underlying stock that the calls are being sold against. For example someone owns 100 shares of stock ABC. A covered call strategy involves selling calls against those shares in hopes of generating additional income on their stock position. Please see our educational webpage about covered calls to get more details.
Naked (uncovered) Calls
In the case of selling calls uncovered, the trader doesn’t have the shares to cover the option if the buyer exercises their call option. A trader that sells naked calls is taking on more risk because there is no limit to the amount of money that can be lost on the trade. Please see our educational webpage about naked calls to get more details.
Call spread strategies involves selling two calls simultaneously with different strike prices and/or expiration dates. Spreads limit the amount of money a trader can lose on any specific trade, but also limits the potential profit at the same time. Please check out the different call spread strategies throughout our website.