People usually buy calls for one of three reasons:
- To take a view on a stock going up for less money up front. A $200 call can give you exposure to 100 shares that would cost $5,000 to buy outright.
- To cap the downside on a view. The loss is limited to the premium, however far the shares fall. If the share price falls just $2 and you own 100 shares you've lost the equivalent to the premium of the option.
- To lock in a price for later. Someone expecting cash in a few months can use a call to fix the price they'd be happy to pay.
What is a call?
A call option gives you the right, but not the obligation, to buy a share at a fixed price (strike price) on or before a set date (expiration date).
For this right, you pay a fee, called the premium.
Each contract has a multiplier, usually 100, meaning it represents 100 shares. The premium is quoted per share, so a $2 premium costs $200.
If the share price is below the strike price at the expiration date, the option will expire worthless and you will lose the entire premium.
As the share price moves up and down, the value of the option will change.
You are not required to hold the option until expiration and can sell beforehand.
Key terms
Think of it like a holding deposit on a house
Say you find a house for £300,000. You pay the seller a £5,000 holding deposit to hold that price for three months while you decide.
- If during that time prices jump and the house is now worth £340,000, you have the right to buy it at £300,000.
- If prices fall, you walk away and lose the £5,000 and nothing more.
A call option works in much the same way. The agreed price is the strike price, the deposit is the premium, and the three months is the expiration date.
A worked example
This example is hypothetical. It uses a made-up company and ignores fees, commissions and currency costs.
Shares in Example Co trade at $50. You think the price might rise over the next three months, so you buy one call option:
- Strike price: $55
- Expiration date: three months away
- Premium: $2 per share
One contract usually covers 100 shares, so the call costs you $2 × 100 = $200.
To make your money back, the share price has to rise above the strike price by at least the premium you paid: $55 + $2 = $57. This is known as the breakeven.
Here's what the trade looks like at the expiration date for a range of share prices:
If the shares end below $55, however far below, the most you lose is the $200.
What you can lose
When you buy a call, the most you can lose is the premium you paid.
- You can lose 100% of what you put in. If the share price doesn't rise above the strike by the expiration date, the call expires worthless.
- Being right isn't always enough. In the example, the shares rose from $50 to $54 and you still lost the full $200 as the share price is still below the strike price. Importantly, the share price has to move far enough, and soon enough.
- Time works against you. An option loses value as the expiration date gets closer, even when the share price stays flat. This is called time decay.
- Leverage goes both ways. A small move in the share price can mean a large percentage gain or loss on the option.
Selling (or "writing") calls is a different matter and carries larger risks. We cover it separately.
What's next
Calls are half the picture. Next comes the opposite, a put option.
The right to sell at a fixed price, which is in many ways the mirror image of a call.