What is a Call?


Call contracts are a directional speculative bet, buying a call is bullish (I think the underlying is going to go up) and selling a call is bearish (I think the underlying is going to go down). A bought call is referred to as a long call, a sold call is referred to as a short call.

 

Buying a call costs a debit and selling a call gives you a credit. When buying a call contract you have capped losses (the price of the contract), with infinite gains (the difference between the strike and infinity). When selling a call contract you have capped gains (the credit received), with infinite losses (the difference between the strike and infinity). We can limit these losses by making sure we have covered our contract via stock or a long call at a lower strike. 

Because they are contracts, there are rights and obligations involved with these transactions. If you buy, you have the right, but not the obligation, to purchase 100 shares times the number of contracts at the strike price on the date of expiration. If you sell, you have the OBLIGATION (this is important) to SELL 100 shares times the number of contracts on the date of expiration at the strike price. 

 

Let’s see an example of this. You buy 1 call option on ticker X, with a strike of 15 expiring on the 15 of March for $1.00. Remember that each contract is a bundle of 100 shares so buying 1 contract @ $1.00 would cost you $100. The current share price of X is $10, so this contract is OTM. Let’s say on March 15 X is trading at $20. Nice job, you can exercise this contract to buy 100 shares at $10! Let’s say on March 15 X is trading at $5. No one is going to pay for shares of a stock at $10 when they can just go out and buy them on the market for $5, so this contract expires worthless. You’ve now lost your entry fee of $100. 

 

Let’s use this same example but with selling a call option. If I speculate that the price won’t go above $15, I can sell a call at that strike. So I sell a call at the 15 strike and receive a $100 of premium for that sale. If the stock goes to $20, I am obligated to sell 100 shares at a price of $15. If the stock goes down to $5, I collect my premium and carry on with my day.

 

There are two ways to sell calls, covered or naked. A covered call means I own 100 shares of the underlying stock and sell the call against these shares, selling a naked call means I do not own any shares of the stock. If you sold this call naked at 15 and the share price goes to $20, you have to go out onto the market and buy 100 shares at the current price of the underlying to complete your obligation. 

If this was covered and your initial share price was $10, well you made money on the stock moving up and on collecting premium for selling your call, but you left some profit on the table because you could’ve sold it at $20 if you weren’t contractually obliged to sell at 15.