A Guide to Call Options

The call option, probably the most popular derivative instrument (a security whose price is derived from another security) prior to this current financial crisis. If you have spent any time around finance or watching CNBC and you will have heard call options mentioned at least once. If every time you hear that word you think to yourself 'What does this mean? What are these things?' then this guide is for you. An option is simply a contract between two people where one person agrees to sell a specified amount of a good to another person at some set price and a future date. Additionally, the person who buys that contract generally pays a premium for the option to do this. Today we will specifically discuss call options; what they are and how they are used.

A call option is an option where the buyer of the option has privilege of buying a certain amount of a good (with stocks it is 100 shares of that stock) at a later date and a specified price. The reason traders and investors prefer to buy call options is because the price that is paid when you buy an option is a fraction of what it would cost to buy the equivalent amount of shares, even when the option is priced 'at the money' (when the price that you can buy the shares for with the option is equal to the price it is trading at right now).

Often, a small investor will try to bet on stocks by buying options because it allows them to use much more leverage than just buying the stock. In finance, this is called being 'long call options' and is one of the most popular ways to add leverage or just invest in stocks with options. Selling options is another big way for individual investors to make money in the stock market. Many times, when someone holds a big portfolio that contains hundreds of shares of stock, they will sell call options on stocks they own (often they sell 1 call option for each 100 shares of stock they have). When the strike price (the price that the seller agrees to sell the stock at) on the option is greater than the price of the stock currently, it is called a covered call. Selling covered call is considered an investment strategy because if the price of the stock goes over the strike price and the option buyer takes the stock away from you, you are covered because you already own the stock. Additionally, if the option expires then you as the call option seller get to pocket any money that the option buyer paid you for the option in the first place. Investors love this strategy because it allows them to make income on stock that they own without being forced to sell it. If they do have to sell it and the stock hasn't rocketed up, they are able to rebuy it at roughly the same price.