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Understanding Calls

On our "What are Options?" page we discussed the basics of the basics regarding options. We discussed what options are, and how they can be used, and we also provided an example. 

For Understanding Calls we want to provide a little more detail about Call options, and also provide examples that will help you grasp the concepts better. Remember there are two types of options, a "call" option and a "put" option. An investor or trader can go long (or buy) a call or a put. And they can also go short (sell) a call or a put. Whether an investor buys or sells a call or a put depends on the investors motives and expectation of the underlying investment instrument.

We will continue using the example from the What are Options? page, PEAR Jan 18 2019 $100. Our hypothetical company Pear (PEAR) is our underlying investment instrument.

Call Options

An investor can buy or sell a call option depending on the investors motives. If an investor believes a stock will increase in price, the investor would purchase a call option for the underlying stock. If the investor believes a stock will decrease in price, the investor would sell a call option of the underlying stock. Using the Pear Call Option below, lets discuss the roles of the options buyer and seller.

                                                                                                                                                        

 

 

 

Call Buyer

As the buyer of a call option, an investor has the right, but not the obligation to buy or sell a security or financial asset at an agreed upon price. As a buyer of the option above, an investor would purchase the option for $15.75, this is known as the premium. When the buyer purchases the option they are buying to open, meaning they are opening a contact with the seller of the option. In this case the buyer of the PEAR Jan 18 2019 $100 call option is expecting that Pear's stock will trade over $100 per share in price before January 18. 2019. 

Scenario 1: Pear's stock is trading at $125 per share.

The buyer of the option can "exercise" the option or "call" the stock away from the options seller. If the buyer were to exercise the option, the buyer could purchase 100 shares of Disney for $100 per share from the option seller, even though the stock is trading at $125 per share. The options buyer would have a $25 per share profit (commissions and transaction fees not included).

Scenario 2: Pear's stock is trading at $125 per share, and the option is trading at $19.50 | $20.00. 

Since the premium of the option increased with the price of the stock, the buyer of the option can sell the option in the market for a higher premium than they paid. The buyer would sell the option at $19.50, making a $3.75 profit or $375 ($19.50 - $15.75 = $3.75 x 100 = $375).

Scenario 3: Pear's stock is trading at $100

The option would be considered "at-the-money." An investor could exercise this option, but in the real world, an investor would likely sell the option to close the position and buy Disney's stock in the open market for $100.

Scenario 4: Pear's stock is trading at $90 per share

The buyer could sell the option to close and attempt to regain a portion of the investment if the option still has value, or the investor could let the option expire and lose the entire $15.75.

A buyer of an option will need to keep Time Value and Time Decay in mind. These are topics that we will discuss later in greater detail, but for now, understand that with an "out-of-the-money" option, as the option gets closer to the expiration date the option loses value because the probability of the stock trading over the strike price decreases. This relates to scenario 4. If Pear's stock is trading at $90 per share in December 2018, the probability of Pear's stock trading over $100 per share before January 18, 2019 is very small, and therefore the option decreases in value. 

Call Seller or Writer

A seller of a call option is obligated to sell the underlying security at the strike price to the option buyer if the option is exercised. A seller or writer of a call option is hoping the underlying security or investment instrument decreases in price or stays "at-the-money." Using our option example above, the call writer would receive $15.25 for each PEAR Jan 18 2018 $100 call they sold, this is how options can be used to generate income. There are two types of calls an investor can write, covered and naked.

Covered Call

Writing a covered call. This means the writer of the call owns the underlying stock. For example, an investor owns 100 shares of Pear stock and sells the PEAR Jan 18 2019 $100 call option. This would be considered a covered call. Usually for this strategy the call writer sells an out-of-the-money call. With a covered call, if the option buyer exercises the option, the call writer will transfer their 100 shares of Pear stock to the option buyer.

Naked Call

Writing a naked call. This means the writer of the call does not own the underlying stock. Continuing with our example, an investor sells the PEAR Jan 18 2019 $100 call option even though they do not own 100 shares of Pear's stock, this would be considered a naked call. With a naked call, if the option buyer exercises the option, the call writer will have to buy 100 shares of PEAR stock in the open market and then transfer it to the option buyer.

Let's go through the scenarios from above as a call option writer.

Scenario 1 Covered Call: Pear's stock is trading at $125 per share.

The buyer of the option "exercises" the option or "calls" the stock away from the options seller. The seller must now transfer 100 shares of their Pear stock to the options buyer. The call writer would keep the premium they collected from selling the call, but they would no longer own their 100 shares of Pear stock.

Scenario 1 Naked Call: Pear's stock is trading at $125 per share.

The buyer of the option "exercises" the option or "calls" the stock away from the option seller. The seller must now enter the open market and purchase 100 shares of their Pear's stock at $125 per share, then sell it to the option buyer at $100. The option seller or writer will lose $25 per share.

Scenario 2 Covered or Naked: Pear's stock is trading at $125 per share and the option is trading at $19.50 | $20.00. 

Since the premium of the option increased with the price of the stock, the seller can attempt to cut their losses early by purchasing the option in the market at $20.00. This will close the option writer's position and leave them with a $4.25 loss, $15.75 premium received minus $20.00 spent to close the option.

Scenario 3 Covered or Naked: Pear's stock is trading at $100

This option would be considered to be "at-the-money" since the underlying stock is trading at the same price as the strike price. An investor could exercise this option, but in the real world, the option buyer would likely sell the option to close the position and buy Pear's stock in the open market for $100 or let the option expire worthless. In this case the option seller keeps the $15.75 in premium they collected and if they own Pear's stock, they will keep their stock as well.

Scenario 4 Covered or Naked: Pear's stock is trading at $90 per share, and the option is trading at $8.50 | $9.00

The option seller would be considered to be "in-the-money" since the underlying stock is below the strike price. The option seller can take a profit by buying back the option they sold for $9.00 and closing the option. This would result in a $6.75 profit, $15.75 premium received minus $9.00 spent to close the option. The other choice is to let the option expire, which would allow the option writer to keep the $15.75 premium collected and their PEAR stock if they owned the stock.

Writing Naked Call Options

Writing naked call options can be extremely risky. Essentially the writer of a call option is hoping that the stock decreases in price, but in theory a stock could go to infinity (no stock has ever gone to infinity). Every dollar the underlying stock increases over the strike price increases the options seller's loss. In our example with the PEAR Jan 18 2019 $100 call option, Pear is selling at $100 per share at the time the option was sold. If Pear increases to $300 per share before the option expiration date and the buyer calls the stock away, the investor who wrote the option will have to buy Pear at $300 per share and sell it to the option buyer for $100 per share, ending the option seller's investment with a $200 per share loss or $20,000 total loss ($200 per share loss x 100). This is where scenario 2 from above comes into play. The call option writer hoped that Pear's stock would decrease in price when they wrote the option, but the stock increased instead. The option writer can enter the market and close the position taking a small loss, instead of incurring a larger loss later.

We hope that this helps you get a better understanding of call options. Keep an eye out for more articles coming to our Beginners Block. Get notified about our new articles, reports, and research by leaving us your email. If you have a question for us please email us here.