What is a 'Call Option'
A call option is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period.
It may help you to remember that a call option gives you the right to call in, or buy, an asset. You profit on a call when the underlying asset increases in price.
BREAKING DOWN 'Call Option'
Call options are typically used by investors for three primary purposes. These are tax management, income generation and speculation.
How Options Work
An options contract gives the holder the right to buy 100 shares of the underlying security at a specific price, known as the strike price, up until a specified date, known as the expiration date. For example, a single call option contract may give a holder the right to buy 100 shares of Apple stock at a price of $100 until Dec. 31, 2017. As the value of Apple stock goes up, the price of the options contract goes up, and vice versa. Options contract holders can hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock or sell the options contract at any point before the expiration date at the market price of the contract at the time.
Options Used for Tax Management
Investors sometimes use options as a means of changing the allocation of their portfolios without actually buying or selling the underlying security. For example, an investor may own 100 shares of Apple stock and be sitting on a large unrealized capital gain. Not wanting to trigger a taxable event, shareholders may use options to reduce the exposure to the underlying security without actually selling it. The only cost to the shareholder for engaging in this strategy is the cost of the options contract itself.
Options Used for Income Generation
Some investors use call options to generate income through a covered call strategy. This strategy involves owning an underlying stock while at the same time selling a call option, or giving someone else the right to buy your stock. The investor collects the option premium and hopes the option expires worthless. This strategy generates additional income for the investor but can also limit profit potential if the underlying stock price rises sharply.
Options Used for Speculation
Options contracts give buyers the opportunity to obtain significant exposure to a stock for a relatively small price. Used in isolation, they can provide significant gains if a stock rises, but can also lead to 100% losses if the call option purchased expires worthless because the underlying stock price went down. Options contracts should be considered very risky if used for speculative purposes because of the high degree of leverage involved.