What Are Call Options?
A call option is a contractual agreement between a buyer and seller which gives the right, but not the obligation, to the buyer to acquire a specified number of shares in a security at a predefined price (strike price) within a predefined amount of time. Each options contract represents 100 shares in the underlying security; for example, 10 Apple July 09 $125 call options will allow the holder of the call option to purchase 1000 shares of Apple at $125 on or before options expiration week in July 2009.
Call options can be bought, sold, and even shorted. They are predominately used for purposes of hedging but many traders will use them for speculative purposes as well. For example, the most popular hedging strategy using calls is known as a covered call strategy. Traders will short calls to offset a portion of the downside risk of a stock that they own or lower the net cost of purchasing the stock. Conversely, a speculator may sell a call option without owning the underlying security. This is known as a "naked" call and carries an unlimited risk. Remember, you are basically selling another trader the option to buy a stock at a certain price; therefore, the higher that the underlying moves, the more money you lose.
You can generally say that the price of a call option moves higher as the stock moves higher and vice versa. The risk of buying a call option is merely the amount of money that was paid for the option. The upside profit potential of a long call option is unlimited.
Advantages of Call Options
Buying call options introduce two distinct advantages to a trader. First, they provide traders with a large amount of leverage. In our Apple example above, assume that the call was trading at $10. Therefore, the buyer would have to pay $10,000 ($10 * $120 * 10) to control 1000 shares of Apple which currently trades at $120. You can see there is a 10 times leverage factor in this example. If Apple runs up to $140 and the call option is exercised, a $10,000 profit will be realized or 100%.
Secondly, as we have discussed above, call options allow traders to hedge their long positions, but not totally eliminate the risk.
Disadvantages of Call Options
The key disadvantage to buying call options is that it will expire worthless if you buy it and the underlying security does not move higher. However, if you sell an option, this is exactly what you want to see happen. Additionally, in the wrong hands, options can be very dangerous. Some traders may speculate that the market is going to move lower and sell a boatload of calls only to watch the stock move higher and put them on the hook for delivering the shares.
Reading a Call Option Chain
Notice in our example here, there are three main components of an options chain. First, notice the expiration date in the second column. This is the date that the option will expire and the option must be exercised on or before this date. Second, notice the price next to the date. This is referred to as the strike price. The strike price is the price at which the buyer of the option may call the underlying security at. Finally, the “Last” column represents the price at which this option is trading at. Another important piece of information has been left off this image. Open Interest allows us to understand how much interest there is in a certain option. This can allow traders to uncover any abnormally large bets being placed.