A Beginner's Guide to Call Options

If you're new to options trading, call options can seem like a daunting concept. However, with a basic understanding of how they work, call options can be a powerful tool for investors looking to profit from market movements. In this guide, we'll cover the basics of call options, including how they work, their advantages and disadvantages, and how you can get started with options trading.

What are call options? Call options are a type of options contract that give the buyer the right, but not the obligation, to purchase a specified amount of an underlying asset, such as a stock, at a predetermined price (known as the strike price) within a specified time frame (known as the expiration date). The buyer pays a premium to the seller for the right to buy the asset at the strike price.

How do call options work? To understand how call options work, let's take an example. Suppose you think that the stock of Company X, which is currently trading at $50 per share, will increase in value in the near future. You can buy a call option with a strike price of $55 and an expiration date of one month from now for a premium of $2 per share. If the stock price increases to $60 per share, you can exercise your option and buy the shares at the strike price of $55, then sell them for $60, making a profit of $3 per share minus the premium of $2 per share.

Let's use a real-world non-financial example to understand call options better.

Let's say you have a friend, Sarah, who is an artist and she creates beautiful paintings. You believe that Sarah's paintings will become very popular and increase in value over time.

To protect yourself against the possibility of Sarah raising the price of her paintings, you decide to buy a call option from her. This call option gives you the right to buy one of Sarah's paintings at the current price of $500 within the next six months. In exchange for this right, you pay Sarah a premium of $50.

A few months later, Sarah's paintings are featured in a prestigious art exhibit, and they become very popular. The market price for her paintings increases to $800 each. But since you bought the call option, you have the right to buy a painting from Sarah for only $500. You can then sell the painting at the market price of $800 and make a profit of $300 per painting.

So, by buying the call option, you were able to protect yourself against the possibility of Sarah raising her prices and also benefit from the increase in market value of her paintings.

Of course, since Sarah is your friend, you should support her art regardless of the price :)

Now that you understand call options from a higher level, let's talk about advantages of using call options. One of the main advantages of call options is that they offer the potential for significant profits with relatively low upfront investment. Call options also offer flexibility, as the buyer can choose whether to exercise the option or let it expire. Additionally, call options can be used to hedge against potential losses in a portfolio.

As advantageous as call options are, there are disadvantages to using call options. Let's talk about some disadvantages. One of the main disadvantages of call options is that they expire, and if the underlying asset does not increase in value, the buyer loses the premium paid. Additionally, options trading can be complex, and inexperienced traders may be susceptible to making costly mistakes. I've definitely made many costly mistakes myself while learning.

As we conclude this beginner's guide to call options, it's important to note call options can be a powerful tool for investors looking to profit from market movements. By understanding the basics of call options, you can make informed decisions about how to incorporate them into your investment strategy. Remember to do your research and work with a reputable brokerage firm to get started with options trading.

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Vijay Kailash, CFA
Founder & Lead Instructor at OptionSellingSecrets.com