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What is a call option?

What is a call option

A call option definition is an option contract that gives the buyer the right, but not the obligation, to purchase an agreed quantity of an underlying asset at the predefined price (strike price) within a fixed period of time until its expiration date.

This is the opposite of a put option. In this situation, the seller, also known as a call writer, is the one with the obligation and will have to sell the asset at the strike price if the buyer decides to exercise the option.

Where have you heard about call options?

We have all heard of options. They might seem quite overwhelming, but if understood correctly, they can open a whole new world of opportunity for a trader. Today, these derivatives are very popular among online traders. Call options, in particular, are favoured by many as they provide high capital potential and relatively little risk. You can buy and sell call options through brokerage trading accounts.

What you need to know about call options.

As a matter of fact, there are two types of options – puts and calls. In every option transaction, there are two parties involved – the seller (also called the ‘writer’) and the buyer. Each side participating in the trade has its own potential profits and risks.

When it comes to call option trading, the buyer takes a long position while the seller takes a short position.

You can characterise a call option as a bullish bet that the underlying asset is going to rise in price in the foreseen future. In case its value does go up, you will be able to make a profit by exercising a call option and actually buying the asset at a lower price than the current market value.

One of the biggest advantages of this type of trading is that you can exit the option before it expires.

An option premium is the market price of the call option and is paid for the rights that the option grants. If at expiration date the underlying asset is below the strike price, the buyer loses the premium paid. Сonversely, if the asset’s price is above the strike price by the time of expiry, the price differential between the two is the profit that is then multiplied by the number of shares purchased.

Sometimes, options are compared to future contracts. However, the major difference between the two is that buying a call option limits your losses to the premium you paid, commissions and fees (if any). With a future contract, you have an unlimited loss potential as you are obliged to execute the trade.

Another thing that traders should be aware of is that the overall value of a call option depends on whether it is "in the money" or “out of the money”.

“In the money” refers to a call option where the strike price of the underlying asset is below the current market price, so you can exercise your contract and make a profit right away. However, since "in the money" contracts have more intrinsic value, they are more expensive, so you will have to pay a higher premium for it.

Conversely, "out of the money" call options are those whose underlying asset price is below the strike price, making the option more riskier but also cheaper.

The market price isn't the only thing that has an impact on a call option – time value also plays a large role in determining an option's price. When purchasing a call option, its time value is defined by the time remaining until its expiration. The longer the time of its validity, the more expensive its premium will be, as it has more time to become "in the money”. Vice versa, the less time an option has before its expiration, the less its time value is and the cheaper its premium will be.

Additionally, much like regular securities, options are subject to volatility. The higher volatility of the underlying asset results in a more expensive option.

Call option strategies.

Now that we know the call option definition, we can move on to the strategies you can employ when trading call options. In fact, there are a large number of these. Here, we gathered the most popular, and yet simplest, ones:

The long call. One of the easiest ways of trading call options is a long call strategy. It involves buying call options and hoping that the underlying asset is going to rise in price before the expiration date. Going long with call options can provide you with much higher returns than buying the same amount of the underlying stock itself. Newcomers often start off their options trading journey by employing this strategy.

The covered call. It is one of the most popular options trading strategies that is favoured by many. The covered call technique is used to maximize potential profits by selling call options on stocks that you already own in your portfolio. The idea is to earn the premium while also benefiting from the stock rising. The covered call is usually used as a short-term hedge in a bullish market.

Bull call spread. This strategy revolves around purchasing call options at a specific strike price and simultaneously selling the same number of call options for the same expiration date at a higher strike price. The main goal of it is to reduce the overall cost of the trade. By employing this technique, a trader limits his gains and losses, reducing the risk involved, as the loss can’t be more than the initial cost paid to enter the spread position.

Bear call spread. This strategy involves buying call options at a higher strike price while also selling the same quantity of calls with the same expiration date at a much lower strike price. This strategy is used when a trader expects a decline in the price of the underlying asset. In this case, the calls sold at a lower strike price will always generate more income than the calls bought at a higher one. If the market price of the underlying asset is lower than the strike price of the calls sold, you keep the cash. If it trades higher, the purchased calls reduce the upside risk.

As there are a lot of different techniques available, you have to be sure to do your research and pick the one that best suits your experience and goals. It is recommended to always diversify your options and incorporate both bullish and bearish strategies, as it will minimise the loss risk and increase your chances of having winning positions in your portfolio.

Find out more about call options.

To learn more about options, check out our free online course on the related topic.

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