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How Call Options Work I – The Basics

Preet, the full time Bay Street stock broker and blogger at WhereDoesAllMyMoneyGo, has written another great article for MDJ about How Call Options Work.  I initially planned to write the article, but thought it would be best to have an article from a trader experienced with the ins and outs of options.  This is Part 1 of a 3 part series.

Thanks again to Frugal Trader for asking me to create a guest post for his readers. I was asked to create a primer on call options this time – so here is my shot at it – I hope you find it informative!

THE BASICS

The first thing to note is that OPTIONS when used in the context of CALL and PUT OPTIONS are different from EMPLOYEE STOCK OPTIONS which are issued by companies to their employees. EMPLOYEE STOCK OPTIONS are an employee benefit that represents the ability to purchase treasury shares right from the company at a specified price for a specified period of time (usually 2 years or thereabouts). This post is not about employee stock options.

No, this post is about the “other” type of options – of the CALL option and PUT option varieties. Options are both a very simple concept and at the same time a very versatile and complex portfolio management tool. There are very conservative option strategies and VERY risky option strategies. More press is given to the riskier strategies unfortunately, and quite frankly I think most investors should explore the use of the more conservative options strategies for their own portfolios as I will attempt to show. Every time I explain some simple option strategies to investors, eyebrows are raised and questions are asked… There just isn’t enough information and investor education on options out there.

Let’s begin by talking about Call Options today. Options are a type of “derivative” – and a derivative is a security “whose value is derived from the value of something ELSE”. What it means in this case, is that when you purchase a call option on a stock – you haven’t actually bought the stock, but the value of the option is related to the value of that “underlying” stock. I’ll spare you the academia from this point on and just get right to the nitty-gritty… J

When you buy a Call Option, you are buying the OPTION to purchase a stock in the future for a set price, for a set period of time. This would be advantageous if you thought the stock was going to go up in the future. Also of note, is that call options provide for a degree of leverage (allowing you to increase your potential returns) and also limit your potential losses.

Let’s examine a typical Call Option quote on the stock ABC, which has a current stock market price of $50:

Option Type Security Expiry Strike Price Premium
 Call ABC Apr 55 2.50

Reading from left to right: This quote is for a CALL OPTION on the security ABC. The option contract EXPIRES IN APRIL. The STRIKE PRICE of $55 is what the option holder can purchase the shares of ABC for anytime up until the 3rd Friday of April. To purchase the ability to do this would cost the option holder $2.50 per contract per share.

Not quite as easy as a typical stock quote and certainly some quirks too! Probably the thing that sticks out most is that all options expire on the third Friday of the month listed. That means the option holder has the ability to exercise their option up to AND including the third Friday of the month – otherwise the option expires on the Saturday.

The second thing that I want to point out is the “strike price”. If you were to purchase this option contract, you would have the option of buying 100 shares of ABC for $55 per share, no matter what the stock was trading at. Obviously it would make no sense to “exercise your option” and purchase shares of ABC for $55 today when they are only trading for $50 on the open market. If, on the other hand, ABC was trading at $70 before April, you could still buy it for $55 since that is the option you have bought. Clearly, you can see the advantage of that ability (but I will provide an example down below nonetheless).

Thirdly, note that I mentioned the quantity of 100 shares. Each option contract is specified for 100 shares of the underlying stock. So even though the premium (the price to buy this Call Option Contract) is $2.50 – your outlay will be $250 ($2.50 x 100 shares).

Fourthly, when the value of the underlying stock starts trading ABOVE the Strike Price, the option contract is said to be “IN-THE-MONEY”. When the stock price is equal to the strike price, it is “AT-THE-MONEY”. And finally, when the stock price is BELOW the strike price – the option is “OUT-OF-THE-MONEY”.

Option contracts would be used as followed in financial parlance:   I own an April 55 Call on ABC.

Part 2How Call Options Work – Examples

Part 3Call Option Writing

Part 2, which includes Call Option examples, is coming up soon!  In the mean time, check out WhereDoesAllMyMoneyGo for more advanced investing strategies.

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8 Comments

  1. The Chef on November 15, 2007 at 8:31 am

    Awesome Post! I loved it, you have explained the concept of call option so lucidly that everybody can understand.

    I never did derivatives but I always did my invsting through cash and carry. May be in future say 1-2 years i ll get into it. Waiting for your Put option article

  2. WhereDoesAllMyMoneyGo.com on November 15, 2007 at 1:52 pm

    Thanks Chef – appreciate the kind words. :)

    Part II will include some examples – how an option trade looks when you are “in the money” and also how it looks when you are “out of the money”.

    Part III will include some conservative strategies that almost everyone should seriously consider using. But I will leave it to the readers to decide after they have read it of course! :)

  3. Pinyo on November 17, 2007 at 1:01 pm

    Thank you. You are doing a great job of explaining and intimidating concept in an easy to understand way.

  4. Derek on November 18, 2007 at 4:26 am

    Nice call..

    I think forwarding your readers to the montreal home page http://www.m-x.ca/accueil_en.php will help your readers. It has great examples and offers quotes for all Canadian optionable companies and ETF’s plus past history to show how an option price really moves relative to underlying shares (known as Delta).

    Also http://www.optionmatters.ca offers some interesting comments on options. One comment on your article. With regards to selling calls your shares can be taken at any time from you … watchout just before ex. dividend date if the call is ‘in the money’.

    Also if you own calls in the money by more than $0.25 they get exercised automatically for you so make sure you have enough money to buy those shares in your account!

    DH

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  7. Dividends4Life on November 19, 2007 at 5:30 pm

    Great article! There is a mystery around options that make a lot of investors uncomfortable.

    Friday when I run down the articles I most enjoyed from the Carnival of Personal Finance #127, I plan to provide a link to yours.

    Best Wishes,
    D4L

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  11. CoveredCallsTutorial.com on November 24, 2007 at 1:48 am

    Excellent primer on call options and serves as good background for Part III on writing covered calls.

  12. WhereDoesAllMyMoneyGo.com on November 24, 2007 at 2:04 am

    Derek – I think it might be broker-specific that your call options get exercised when they are $0.25 in the money, as with full service brokers we can hold options until they are actually exercised by the option holder.

    We can even sell in the money options (by a few dollars). I know a broker in the office that does that routinely.

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  22. sudhakaran on May 26, 2010 at 2:35 pm

    High quality explanation.

    Thank you,

    sudhakaran.

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