Call Option: Definition, Types, Pros, Cons

Trader exercising a call option.
A trader works on the floor of the New York Stock Exchange on December 4, 2013 in New York City. The Dow Jones Industrial Average dipped over 100 points during trading before bouncing back to approximately 15,900; the market peaked at a record high last month at over 16,000 points. Photo by Andrew Burton/Getty Images

A call option gives you the right to buy a stock at an agreed-upon price at any time up to an agreed-upon date. The agreed-upon price is known as the strike price. The agreed-upon date is the exercise date.  You pay a small fee, or premium, for this right, which is the contract. Call option contracts are sold in 100-share lots. 

A call option, or call, is a derivative. Its value is derived from the price of an underlying real asset.

In this case, the asset is the stock. 

Buying a Call Option

Buyers of call options are called holders. If you are a holder, you make money in a rising market. You hope the stock price rises higher than the strike price. That has to happen before the agreed-upon date.

If that happens, you'll exercise the option. That means you can buy the stock at the strike price. You can then immediately sell it at the higher price. You might also wait to see if it goes even higher.

Your profit equals the stock proceeds, minus the strike price, the premium for the call option, and any transactional fees. That is known as being in the money. The profit is the option's intrinsic value.

If the stock price doesn't rise above the strike price, you won't exercise the option. Your only loss is the premium. That's true even if the stock plummets to zero.

Buying a call option gives you more leverage. You can make a lot more money if the price rises.

You only lose a fixed amount if the stock price drops. As a result, you can put more of your money at risk.

The other advantage is that you can sell the option itself if the stock price rises. That means you've made money without ever having to pay for the stock.  (Source: , Investopedia)

Selling a Call Option

The person who sold you the call option is called a writer. He makes money from the premium you pay him. He also makes money if the strike price is higher than what originally he paid for the stock. 

He hopes the stock price drops below the strike price, and you don't exercise the option. There are two ways to sell call options.

Naked Call Option: A naked call option is when you sell a call option without owning the underlying stock. It's perilous. If they buyer exercises his option, you have to buy the stock at the prevailing price to satisfy the order. If the price is higher than the option, you'll lose the difference (minus the fee you paid him.) There is no limit to your potential loss since there's no limit on how high a stock's price can rise. You've got to hope that the fee you charge is more than enough to pay for your risk.

Covered Call Option:  A covered call simply means you already own the stock that you are writing the call on. Therefore, the option is "covered" by the stock. Your profit is the fee you charge for the option. You also can keep the difference between the strike price and what you paid for the stock. If it falls before or on the exercise date, you get to keep the fee.

 

The only downside risk is that you'll miss out if the stock price skyrockets. You can't sell it at that price. Instead, you've got to hold onto it. You can only sell it to the option holder at the strike price. You're most likely to write a call if you believe the stock price will drop. (Source: , Fidelity)

Call Versus Put Option

The opposite of a call option is a put option. That gives investors the right to sell the stock at an agreed-upon price at any time up to an agreed upon date.