A call option is a type of option contract that give the holder the right to buy the stock or other security on the contract at a set price in the future. The set price on the call is known as the strike price.
Call Option Definition and Trading
The risk with calls or any other option purchased for trading is the premium paid is 100% at risk. Call options also have short term expirations, so the time frame to profit is limited.
When an investor buys a call option, they want the market to go up. This allows the investor to either trade the contract back to the market for a gain or to exercise the option (buy the stock at the strike price) at a lower price than the actual market on the stock.
A buyer of a call option has an unlimited gain potential, because the strike price is fixed, but the market on the stock could rise to an infinite amount.
An options trader can also short or sell call option contracts. Shorting calls uncovered can be risky. The investor is getting a premium amount for selling the contract, which is the benefit for doing this, but the obligation can result in a loss.
When you short call options, you are obligated to deliver (sell) shares of the stock (if the contract is exercised) to the buyer. If the market is higher than the price you must sell the stock at, you will lose that difference. This would be known as naked call selling. The way to limit a loss is to own the stock and create a covered call strategy.
Covered Call Option
If an investor owns stock and wished to generate premium income as a trading strategy, they could sell calls and create a covered call set up. The stock will be hedged with the premium received on the option. At the same time, the option itself is covered, because if the option is exercised - the stock owned can be used to make the stock delivery. In a naked or uncovered set up, the underlying security is not owned.
Buy 100 shares of ASD at $49
Short 1 ASD 55 Call at $400
This is a covered call set-up. The premium received helps the stock position by lowering the cost from 49, down to 45 (premium less stock price). So, if the stock stays unchanged - the investor still makes money. If the market rises above 55, the call option will most likely get exercised. That is not a problem here, as the shares can be delivered to the call holder. This investor wil make money if that happens, since the price the stock is owned at is lower than the strike price to sell at.
The options trader in the above example can only lose money if the stock value trades lower than 45 - which is the break-even point. The maximum gain is $1000. That is based on the 6 point spread between the stock price and strike price, plus the premium gained.
The maximum loss is if the stock declines to zero. The whole stock is at risk - minus the premium. In this case, that number is $4500.
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