This article explains the rationale behind the sale of call options on shares and how they vary from direct stock ownership.
What Is a Call Option?
Call options, sometimes known as "calls," are a kind of derivative investment contract that allows the buyer the liberty but not the responsibility to purchase an asset or other financial property at a certain price, thus the strike price within a given time period. If the option's buyer exercises their right to buy, the option's seller must sell the security to them. The option's buyer may put the option to use at any moment before the option's set expiry date. The deadline may be in a span of months, even a year.
Buying and selling a Call Option
The amount paid to the option's seller depends on the current market price of the underlying securities, the time left before the option's expiry, and the strike price of the option. That is to say, the option's cost is determined by the probability that the buyer will be able to make a profit by using the option before its expiry. Options are typically traded in blocks of 100 shares. An individual who purchases a call option anticipates making a profit if and only if the underlying asset's price rises over the option's strike price.
The objective of the call option seller is to realize a profit from the sale of the option if the asset's price falls before the option expires or never rises above the option strike/exercise price. An option is said to expire "out-of-the-money" (i.e., worthless) if the price of the underlying securities does not rise above the strike price before its expiry date. If the call option expires worthless, the buyer loses the whole purchase price. Alternatively, the option purchaser will be in a position to financially exploit the option if the underlying asset's price increases above the option's strike price.
The two most common methods of selling call options are:
- Covered Call Option. If the call option seller also owns the underlying stock, then the option is "covered." If you anticipate a decrease in the stock price, you may protect yourself financially by selling call options on the underlying equities. If the buyer of an option exercises that option, the seller may avoid taking a loss by "covering" him with shares of stock that he has previously acquired at a price lower than the strike price of the option. The seller will only make money if the stock price goes up to the option strike price. However, he will be safe from any losses below that level.
- Naked Call Option. The term "naked call option" refers to a situation in which a seller of options does not own the underlying stock. Since there is no restriction on the price of a stock and the option seller is not "covered" against possible losses by holding the underlying securities, naked short selling of options is regarded to be extremely risky.
The basics of a call option
The price at which the option may be sold is called the striking price, and the period of time in which the option can be exercised is called the expiry or maturity date. The premium you pay to acquire a call option represents the maximum loss you may sustain per share. The premium is subtracted from the profit gained if the underlying asset's market price is higher than the strike price when the option expires. The number of shares over which the option purchaser exercises control multiplies this amount.
Long call options and short call options are the two primary strategies to trade a call option;
- The Long Call Option
As with any call option, the buyer of a long call option has the right but not the duty to purchase the underlying stock at the option's strike price at some point in the future. A long call gives you the opportunity to buy shares at a lower price in the future. In preparation for a potentially noteworthy event, such as a company's earnings call, you can decide to buy a long call option. A long call option's potential gain is infinite, but its potential loss is restricted to the option's premium. Therefore, the greatest losses that a buyer of a call option will face are limited to the premiums paid for the option, even if the firm does not announce a good earnings beat (or an outcome that fails to meet the market goals) and the price of its shares decreases.
- The Short Call Option
A short call option is the polar opposite of a long call option, as the name suggests. Short call options include a seller's commitment to a future sale of shares at a predetermined strike price. The majority of options transactions involving short call options include covered calls, in which the option seller already owns the underlying stock. If the deal goes against them, the call might assist in limiting their losses. For instance, if the call was uncovered (i.e., they did not hold the shares underlying their option) and the stock's price rose sharply, their losses would increase dramatically.
Methods for Quantifying Call Option Payoffs
What a buyer or seller of a call option makes or loses on a deal is known as the payoff. Keep in mind that the strike price, expiry date, and premium are the three most important factors to consider while analyzing a call option. These factors are used to determine the value of call option payoffs.
Call option payoffs may occur in two instances:
- Call Option Buyer Payoffs
A call option holder is a person who has purchased a call option. The buyer of a call option anticipates that the underlying asset's price will climb over the option's strike price before the contract's expiry date. Earnings are equal to the net revenues from the sale, less the strike price, premium, and other selling costs. There will be no use of the option by the buyer until the price rises over the strike price. If the buyer loses, they lose the amount they paid for the call option's premium.
Here are the formulae for determining returns and profits:
Payoff = spot price - strike price
Profit = payoff - premium paid
- Call Option Sellers Payoffs
There is not much of a divergence in the seller's payment estimates for a call option. Only if the price of the underlying asset drops will be the seller of a put option on that security profit. The potential for loss is either contained or not limited, depending on whether or not the call is covered. In the latter scenario, if the buyer of the option executes the contract, you will be required to buy the underlying shares at the then-current market price (or maybe higher). The premium you get upon the options contract's termination will be your only source of income (and profits).
Payoff and profit may be determined using the following formulas:
Payoff = spot price - strike price
Profit = payoff + premium
There are several factors to keep in mind when it comes to selling call options. Be sure you fully understand an option contract's value and profitability when considering a trade, or else you risk the stock rallying too high.
There are also other determinants to consider when determining the value of call options, such as the current price, price volatility, and risk-free rate.
Application of Call Options
The three main functions of call options are revenue production, speculation, and fiscal management.
- Making Money with Covered Calls
A covered call strategy is one way that investors may profit from call options. Writing a call option, or granting another party the right to purchase your shares, is one tactic used in combination with stock ownership. The option premium is retained by the investor in the expectation that the option would expire without value (below strike price). This tactic increases the investor's income but may reduce their gain if the underlying stock price increases dramatically.
Covered calls are effective because the option buyer will make good on their obligation to purchase shares of stock at the lower strike price if the stock price climbs above the strike price. This eliminates any potential gain for the option writer should the underlying stock rise over the strike price. The premium collected by the writer is all that can be made by selling the option.
- Making Use of Futures Agreements
Contracts for options allow investors to have substantial stock exposure for a little outlay of cash. When used alone, they may generate substantial profits from a rising stock. When a call option expires worthless because the underlying stock price did not rise over the strike price, the investor loses the whole premium paid for the option. When you purchase a call option, the most you can lose is the option's premium.
A call spread is formed when an investor purchases and concurrently sells two or more call options. Since the premium received from the selling of one option may be used to offset the premium paid for another option, they can be more cost-effective than a single call option in certain situations.
- Fiscal management
Options are a tool used by investors to rebalance their portfolios without actually purchasing or selling the underlying asset. For instance, if a person has 100 shares of a certain company but has yet to sell any of them, he or she may be subject to a sizable hidden capital gain. Shareholders who want to limit their exposure to the underlying securities without selling their holdings may do so by exercising their options. In the first scenario, the sole expense to the shareholder is the price of the options contract.
Gains from options trading will be taxed as short-term capital gains, but the particular mechanism for doing so will differ depending on the specific option strategy and holding duration.
Is there a reason to invest in Call Options?
Investors that are "bullish" on the future of the underlying shares will consider purchasing call options. Call options may be a more appealing tool to speculate on a company's future prospects for these investors due to the leverage they give. After all, if you have an options contract, you may use it to acquire one hundred shares of the underlying stock. Indirectly acquiring shares using call options may be an appealing strategy for investors who are optimistic about the future growth of a company's share price.
Is it a bullish or bearish move to buy a Call Option?
Buyers of call options are optimistic since they stand to gain solely if the stock price increases. Hence the purchase of calls is bullish. Selling call options, on the other hand, is a negative action and thus bearish since the seller benefits from a decline in share price. A call buyer has the potential for infinite profit, but a call seller can only make as much as the premium they get from selling the calls.
Conclusion
The buyer of a call option has the right, but not the responsibility, to purchase a stock, bond, commodity, or other asset or instrument from the option seller at a certain price and within a predetermined time frame. The underlying asset is the share of stock, bond, or commodity. Options are a kind of leveraged speculation. A call buyer makes money when the value of the underlying asset rises. The premiums received from the selling of options contracts represent a source of revenue for a call option seller. Call options have different tax implications depending on the method used to make money and the underlying asset.