Calls

In this guide, we'll be discussing what calls are, how they work, the benefits of using calls, some considerations for trading calls, and some examples of call trading. But first, let's start with the basics: what is a call?

A call is a financial instrument that gives the holder the right, but not the obligation, to buy a specified asset at a predetermined price on or before a certain date. Calls are commonly used in the stock market, where they are typically referred to as “call options.” Calls can be bought and sold on exchanges, just like stocks, and they are traded in contracts that represent the right to buy 100 shares of a particular stock.

Now that you have a general understanding of what calls are, let's dive deeper into how they work, the benefits of using calls, and some considerations for trading calls. By the end of this guide, you'll have a solid understanding of calls and how they can be used in your investment strategy. So, let's get started!

What is a Call?

A call is a financial instrument that gives the holder the right, but not the obligation, to buy a specified asset at a predetermined price on or before a certain date. Calls are commonly used in the stock market, where they are typically referred to as “call options.” Calls can be bought and sold on exchanges, just like stocks, and they are traded in contracts that represent the right to buy 100 shares of a particular stock.

How Calls Work

Calls work by allowing the holder to purchase a stock at a predetermined price, known as the “strike price,” on or before a certain date, known as the “expiration date.” For example, if a trader buys a call option with a strike price of $50 and an expiration date of December 31st, they have the right to buy 100 shares of the underlying stock at $50 anytime before December 31st. If the stock is trading at a higher price than the strike price on the expiration date, the trader can exercise their option to buy the stock at the lower strike price and sell it on the market for a profit. If the stock is trading at a lower price than the strike price on the expiration date, the trader can choose not to exercise their option and let it expire, resulting in a loss of the premium paid for the call.

What are the Benefits of Calls

Calls offer a number of benefits for investors and traders:

  • Leverage: Calls allow investors to gain exposure to a stock without committing a large amount of capital. This can be especially useful for traders who are looking to hedge their portfolio against potential losses, as calls can be used to offset the risk of owning the underlying stock.
  • Potential for profit: Calls offer the potential for profit if the stock increases in value. If the stock increases in value enough to offset the premium paid for the option, the holder can exercise their option to buy the stock at the predetermined price and sell it on the market for a profit.
  • Flexibility: Calls offer flexibility for investors and traders. If the stock decreases in value, the holder can choose not to exercise their option and let it expire, resulting in a loss of the premium paid for the option. This can be a useful way for traders to limit their potential losses.
  • Diversification: Calls can be a useful way for investors to diversify their portfolio, as they can be used to gain exposure to a wide range of stocks and industries.

Overall, calls can be a useful tool for investors and traders looking to gain exposure to a stock without having to commit a large amount of capital, as well as for those looking to hedge their portfolio against potential losses. By understanding how calls work and the potential benefits and risks involved, investors and traders can make informed decisions about whether call trading is right for them.

Considerations for Trading Calls

There are a few key considerations for investors and traders to keep in mind when trading calls:

  • Time decay: Calls lose value as the expiration date approaches, which is known as “time decay.” This can be a risk for traders who are holding long positions in calls, as the value of their options may decrease if the stock doesn't increase in value enough to offset the time decay. It's important for investors and traders to consider the time frame of their investment and to choose an expiration date that aligns with their investment goals.
  • Volatility: Calls are sensitive to changes in the price of the underlying stock, which can be affected by market conditions and news events. This can be a risk for traders who are holding short positions in calls, as the value of the option may increase if the stock becomes more volatile. It's important for investors and traders to be aware of the potential for volatility and to carefully consider the risk level of their investment.
  • Premium: The premium paid for a call is a non-refundable cost, which means that it cannot be recovered if the option is not exercised. This can be a risk for traders who are holding long positions in calls, as they may lose the premium if the stock doesn't increase in value enough to offset the cost. It's important for investors and traders to carefully consider the premium when evaluating the potential profit or loss of their investment.
  • Strike price: The strike price is the predetermined price at which the holder has the right to buy the underlying stock. It's important for investors and traders to carefully consider the strike price when evaluating the potential profit or loss of their investment. If the strike price is too high, the option may not be exercised even if the stock increases in value, resulting in a loss of the premium paid for the option. On the other hand, if the strike price is too low, the option may be exercised even if the stock doesn't increase in value enough to offset the premium, resulting in a loss.

By considering these key factors, investors and traders can make informed decisions about whether call trading is right for them and how to best manage their investment.

5 Examples of Call Trading

Here are a few examples of call trading:

  1. An investor buys a call option with a strike price of $50 and an expiration date of December 31st. The stock is currently trading at $45, and the investor pays a premium of $2 per share for the option. If the stock increases in value to $55 on the expiration date, the investor can exercise their option to buy the stock at $50 and sell it on the market for a profit of $5 per share. The investor's total profit would be the difference between the sale price and the strike price, minus the premium paid for the option, for a total profit of $3 per share ($5 – $2).
  2. A trader buys a call option with a strike price of $50 and an expiration date of December 31st. The stock is currently trading at $45, and the trader pays a premium of $2 per share for the option. If the stock remains unchanged or decreases in value by the expiration date, the trader can choose not to exercise their option and let it expire, resulting in a loss of the premium paid for the option.
  3. An investor buys a call option with a strike price of $50 and an expiration date of December 31st. The stock is currently trading at $55, and the investor pays a premium of $2 per share for the option. If the stock decreases in value to $45 by the expiration date, the investor can choose not to exercise their option and let it expire, resulting in a loss of the premium paid for the option.
  4. Sarah is an investor who is interested in buying shares of XYZ stock, but she is hesitant because the stock is currently trading at a high price. Sarah decides to buy a call option on XYZ stock with a strike price of $50 and an expiration date in three months. Sarah pays a premium of $2 per share for the option, which gives her the right to buy 100 shares of XYZ stock at a price of $50 per share anytime before the expiration date. Three months later, XYZ stock is trading at $55 per share. Sarah decides to exercise her option to buy the stock at a price of $50 per share and then immediately sell the stock on the market for $55 per share. Sarah's profit from the trade is $5 per share (the difference between the sale price and the strike price) minus the $2 per share premium that she paid for the option, for a total profit of $3 per share.
  5. John is a trader who is bearish on ABC stock and believes that the price will decrease in the coming months. John decides to sell a call option on ABC stock with a strike price of $40 and an expiration date in six months. John receives a premium of $1 per share for the option, which gives the buyer the right to buy 100 shares of ABC stock at a price of $40 per share anytime before the expiration date. Six months later, ABC stock is trading at $35 per share. The buyer decides not to exercise their option to buy the stock at a price of $40 per share and the option expires. John's profit from the trade is the $1 per share premium that he received for selling the option.

Risks of Calls

It's important to note that calls are not without risk. While they offer the potential for profit and allow investors to gain exposure to a stock without committing a large amount of capital, there are also potential downsides to consider. For example, the premium paid for a call is a non-refundable cost, which means that it cannot be recovered if the option is not exercised. This can be a risk for traders who are holding long positions in calls, as they may lose the premium if the stock doesn't increase in value enough to offset the cost. Additionally, calls are sensitive to changes in the price of the underlying stock, which can be affected by market conditions and news events. This can be a risk for traders who are holding short positions in calls, as the value of the option may increase if the stock becomes more volatile. It's important for investors and traders to carefully consider these risks and to understand the potential benefits and downsides of call trading before making any decisions.

History of Calls

The concept of options dates back to ancient Greece, where they were used as a way to transfer risk between parties. For example, farmers would sell options to buyers who wanted to purchase their crops at a future date, but the farmers retained the right to sell the crops to someone else if they received a better offer. This allowed the farmers to transfer the risk of potential price fluctuations to the buyers, while the buyers gained the opportunity to lock in a price for the crops.

It wasn't until the 1970s that options became a widely traded financial instrument. In 1973, the Chicago Board Options Exchange (CBOE) was founded and began trading call options on a small number of stocks. The CBOE's launch marked the beginning of the modern options market and paved the way for the widespread use of options as a financial tool.

Over the years, the CBOE and other exchanges have expanded the number of stocks that are available for call trading, and options have become an increasingly popular tool for investors and traders. Today, calls and other options are traded on exchanges around the world, and they are used by a wide range of investors and traders, including individuals, institutions, and hedge funds. Options are a versatile financial instrument that can be used for a variety of purposes, including hedging, speculation, and income generation.

Conclusion on Calls

In conclusion, calls are financial instruments that give the holder the right to buy a specified asset at a predetermined price on or before a certain date. Calls can be a useful tool for investors and traders looking to gain exposure to a stock without having to commit a large amount of capital, as well as for those looking to hedge their portfolio against potential losses. However, it's important for investors and traders to understand the risks and considerations of call trading, including time decay, volatility, and the premium paid for the option. By understanding how calls work and the potential benefits and risks involved, investors and traders can make informed decisions about whether call trading is right for them.