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Call Options - Page .. 1 .. 2
Example: A local newspaper advertises a sale on VCRs for only $129.95. The next day Jane goes down to the electronics store intending to purchase a VCR at the advertised price. Unfortunately, by the time she arrives, the VCR is already out of stock. The manager apologizes and gives her a rain check entitling Jane to buy the same VCR for the advertised price of $129.95 anytime within the next two months. Jane has just received a long call option which gives her the right, but not the obligation, to purchase the VCR at the guaranteed strike price of $129.95 until the expiration date two months away.
Scenario 1: A few weeks later, Jane return's to the store to exercise her rain check. The same VCR is now in stock, priced at $179.95. Jane approaches the store manager who agrees to honor the rain-check and sell her a VCR for the advertised price of $129.95. Jane has just saved $50. Her long call option was in-the-money.
Scenario 2: A few weeks later, Jane returns to the store and finds the VCR on sale for $119.95? Her rain check is now worthless because she can simply purchase the VCR at the reduced price. In this case, Jane's call option expired worthless because it was out-of-the-money. Just because you own a long call option doesn't mean you are under any obligation to use it.
Scenario 3: Jane's friend Jeff phones and mentions that his VCR has just broken. She tells him about her rain-check and agrees to sell it to Jeff for $5 (the option premium). The strike price is still $129.95 and the expiration date is 2 months out. However, Jeff is taking a risk. The VCR might be priced lower than the $129.95 strike price in which case the rain-check is worthless and Jeff loses $5.
Call Option Review
- Call options give traders the right to buy the underlying stock at the strike price until their broker’s cut-off time shortly after market close on the last trading day before expiration. A call option is in-the-money (ITM) if its strike price is below the current price of the underlying stock. A call option is out-of-the-money (OTM) if its strike price is above the current price of the underlying stock. A call option is at-the-money (ATM) if its strike price is the same as (or close to) the current price of the underlying stock.
- Buying Calls (long-bullish). The trader believes the market will rise and buys (go long) calls. Buyers have rights. A call buyer has the right, but not the obligation, to buy the underlying stock at the strike price until the expiration date. If you buy a call option, your maximum risk is the money paid for the option, the debit. The maximum profit is unlimited depending on the rise in the price of the underlying asset. To offset a long call, you have to sell a call with the same strike price to close out the position. By exercising a long call, you are choosing to purchase 100 shares of the underlying stock at the strike price of the call option.
- Selling Calls (short-bearish). The trader believes the market will fall and sells (goes short) calls. Sellers have obligations. A call seller has the obligation to sell 100 shares of the underlying stock at the strike price if assigned. If you sell a call option, your risk is unlimited to the upside. The profit is limited to the credit received from the sale of the call. When selling calls, make sure to choose options with little time left until expiration. Call sellers want the call to expire worthless so that they can keep the whole premium. To offset a short call, you have to buy a call with the same strike price to close out the position.
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