What is a call option, exactly? 

Buying a share generally signals that you think its value is likely to increase. Options are simply another way to express an opinion on financial markets, but without trading in the underlying asset.

As a very quick example, say that you think the price of gold will go higher. You could buy gold options instead of buying physical gold. In another situation, a number of independent investors bought call options in meme stocks GameStop and AMC instead of buying actual AMC shares in order to take advantage of the rising share price (more on that in a moment).

Call options can be bought and sold, normally on an options exchange. Buyers are known as call option holders, and sellers are known as call option writers. Trading options is always zero-sum: one party gains exactly what the other loses, minus transaction costs.

A call option seller grants the call option buyer the right, but not the obligation, to purchase an asset at a certain price and by a specific date, known as the strike price and expiry date, respectively. Options contracts may run from less than 24 hours to over a year. Typically, the strike will be lower than the buyer’s expectation of what the future market price might be.

Why use call options instead of owning stock?

Here comes a reasonable question: what is the incentive for an investor to accept options’ additional complexity compared to just buying the stock (or whatever the financial asset is underlying the option)? The main consideration is the timeframe for the trade and the potential risk-to-reward balance.

In particular, the total financial risk to the buyer is limited by design. At the same time, they’re able to make use of leverage: control a large position while putting up only a limited amount of money. At the same time, their potential upside can be huge…assuming they can correctly predict a stock rally.

How does a call option work?

Let’s look more deeply into what it means to buy or sell a call option by elaborating on some of the options terminology just mentioned.

The call option buyer pays the call option writer (seller) a fee known as the premium to seal the contract. The premium is the most the writer can make on the trade. The premium is also the most the buyer can lose on the trade, as exercising a call option is voluntary, unlike a future. It is somewhat similar to a casino’s “house edge”, as option writers typically sell large numbers of options and rely on the law of averages to make money. 

What a call option buyer receives

So, how does a clever investor profit from a call option? When buying an option, you hope the price of the asset will be above the strike price at the time the expiration date comes around. If it does, then the buyer can exercise the option to purchase the shares from the seller at the strike price – or sell the option contract to another options trader.

If the market price is at or below the strike price at the time of expiry, the call option will be worthless. Having purchased such a call option will have cost the buyer the amount of the premium. In this sense, the risk for a buyer is limited, as they cannot lose more than the premium.

What a call option seller gets

Naturally, if you are selling an option, you want the opposite thing to happen to the asset price. Call option writers hope to see the market price remain at or below the strike price when the options contract expires. If this happens, they receive their premium. Assuming the option writer also owns the underlying stock, this can be a mild form of hedging.

If, however, the market price happens to be above the strike price, the options seller is obligated to sell stock to the contract holder at the specified strike price, even at a loss. The seller will still make a profit as long as the premium is greater than the difference between the market and strike prices. However, sellers take on theoretically infinite risk because the asset price could go up infinitely. 

How can I buy a call option?

Your first step is to register for an options trading account. There are a number of online trading websites offering competitive commissions and, in some cases, considerable support to their clients.

How much does a call option cost?

Each contract specifies the amount of a product the option represents. Each stock option is typically for 100 shares of the underlying stock. The options price is quoted as its value per share. 

For example, a call option for Apple with a strike price of $120 is shown above. It is priced at $16.60 to buy (the asked premium) – so the cost to purchase the option is 100 x $14.60 = $1,460 plus commission.

Options contracts are also traded in the secondary market; there’s no requirement for the original holder to hang onto them until the expiration date. This means their prices fluctuate according to the price and volatility of the underlying market they are tied to.

A historic call option example – GameStop

The start of 2021 saw a surge in some of the most speculative areas of the market, including cryptocurrencies and meme stocks like GameStop and AMC shares. This was an unusual event: the price was affected more by social media and public sentiment than company fundamentals, and few institutional investors saw it coming.

At the height of the bullish sentiment, when the subreddit r/WallStreetBets forum had started to come to mainstream attention, even billionaire Chamath Palihapitiya entered the fray in inimitable fashion.

Investors who bought early on during the rising tide, when both the stock price and premiums were still relatively low, did indeed make impressive profits. On the 4th of January 2021, for instance, GME (GameStop’s ticker symbol) closed at $4.31, while out-of-the-money call options with a strike price around $10 to $15 would come at a premium of under $1 per share (or less than $100 per contract). However, the stock reached $37.00 on the 26th, and premiums had risen to several dollars per share – buyers of these later call options presumably expected the stock to continue to rise dramatically. Though it did trade at over $50 and even $100 for brief periods, those who jumped on the bandwagon too late felt some pain as it soon returned to more reasonable levels in February.

One result of this was increasing public interest in investing generally and call options in particular. Another was the market being distorted; essentially, there weren’t enough liquid shares to cover all the call options that had been sold. The most important lesson for the private investor, however, is that timing is everything when it comes to call options. As the saying goes, pigs get slaughtered, especially when good things always come to an end. Though call options have significant advantages, they should not be traded carelessly.