Call Option Definition with a Simple Example
Stock Market Guides is not a financial advisor. Our content is strictly educational and should not be considered financial advice.
If you're having trouble understanding what a call option is, you're not alone. The term itself is not intuitive as far as we're concerned.
First of all, stock options are a tool in the stock market that allows investors to potentially benefit from the movement of stock prices.
They are leveraged, which means you can get more bang for your buck than you can compared to buying the corresponding stock. That extra bang can equate to either more profits or more losses.
When it comes to stock options, there are two types: call options and put options.
Here's a video that gives more context to the definition of a call option:
Call Option Definition
Owners of call options typically benefit when the price of a stock goes up. That is the opposite of put options, where owners typically benefit if the price of a stock goes down.
Here is a simple way to look at it. If you think a stock price might go up, you could buy the stock to capture that potential increase. You could also buy a call option for the same purpose.
So in other words, buying a stock and buying a call option typically both involve the same hope: that the stock price will go up.
If you need more help getting up to speed on options, take a look at our guide to options trading for beginners.
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Call Option Example
Here's an example of how a call option works. Imagine you're looking at Amazon stock.
That's a stock chart for Amazon. Maybe you see that the stock price has been consolidating and you think it's poised to boom within the next few weeks.
You could buy the stock itself, which is $127.90 per share as shown in the image above.
Or you could consider buying a call option.
Here are call options that are available to buy for Amazon:
If we pick one example, say the 127 strike call options, you can buy them right now for 4.30.
Since option contracts each control 100 shares of stock, it means you would pay $430 to buy one call option contract (plus brokerage fees).
Compare that to buying 100 shares of the stock. That would require $12,790.
Now imagine that the stock price of Amazon went up to $140 in the next few weeks. Whether you own the stock or call option position in this example, the value will have gone up.
But the call option required a lot less capital due to the leverage that options afford investors.
Call Options: Other Considerations
The example above offered a pretty simplistic idea of how call options work. There are other factors at play to be aware of, though.
Overcoming Extrinsic Value in Call Options
The price of many options includes some amount of extrinsic value. You can think of it as a premium you pay to be able to control the option.
Due to this extrinsic value, when you buy a call option, the price of the corresponding stock might have to go up some degree just to offset that premium before being able to turn a profit, particularly the longer you hold the option.
Selling Call Options
Our example above demonstrated how it works to buy a call option. But it's also possible to sell a call option.
If you sell a call option, you benefit if the price of the underlying stock does not go up.
Selling a call option also has a different buying power impact than buying a call option.
Picking the Best Call Options to Buy
If you like the idea of using call options as an investment vehicle, then you can consider learning options trading strategies.
If you'd rather leave it to the pros but still want good option investment ideas, you can consider signing up for our options alert service.
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