What is a Call Option?

Buying Stock Options

What is a Call Option? A call option is a contract that grants the buyer the right, but not the obligation, to buy 100 shares of a particular stock, or stock index, at a certain price, anytime before a predetermined date. The buyer is hoping that the price of the underlying stock will increase. If the underlying stock does increase, the buyer makes money by buying the stock at the agreed-upon price, and selling at the higher market price, or selling the option at a price higher than it was originally bought.

Selling Stock Options

The seller of the call option is called the writer. You can write a call by selling someone the option to buy a stock from you at a particular price, before the expiration date.

If you write an option, you are obligated to sell the stock to the option holder, if the holder wishes to "exercise" or buy the stock from you at the predetermined price. When you write a call, you have no control over the contract being exercised. The buyer can exercise at any time before the expiration date. And just like the buyer can sell a call back into the market, you can cover (buy the same call that you sold) to close your position.

Think Of It Like This

This might help you to understand how stock options work.Lets say you have a friend who is selling property in a prime location. He is selling 10 lots for $100,000. He tells you that the lots are selling like hotcakes.

It seems like a profitable investment and you think that the value of the property will increase as the area is developed. But, what if you are wrong and your investment is lost? You could be stuck with property that you can't sell or you end up with a huge loss on your hands.

Your friend tells you that with a $1,000 binder, he will hold a lot for 3 months. If you decide to buy anytime before then, you pay him $100,000 and the property is yours; if you decide not to buy, then you are only out $1000.

He also gives you the right to sell the binder if you choose. So, if the property value sky rockets and someone else wants the lot, then the value of the binder will increase. If the property value begins to drop, and you act fast enough, you can sell the binder for a loss. But, you have at least recouped a portion of the $1,000 binder.

In this example the binder gives you the option, but not the obligation, to buy the underlying asset at a predetermined price, within a limited period of time.

Option Terms

Call
An Option contract that gives the holder the right to buy the underlying stock at a certain price anytime before a predetermined date.

Cover
To buy back and close an option that was initially written.

Exercise
To exercise the right of the holder of an option to buy the underlying security from the writer.

Expiration date
The day on which an option contract becomes void. The expiration date for listed stock options is the Saturday after the third Friday of the expiration month.

Holder
The buyer of an option.

Strike Price
The stated price per share for which the underlying security may be bought by the option holder upon exercise of the option contract.

Write
To sell an option. The investor who sells is called the writer.
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