What You Need to Know about Call Options

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Before you jump into the complex world of options trading, there are a couple of things you need to know about call options in particular.

What are Call options?

A call option conveys the right to buy stock at a specific price at a specific date.

A put option conveys the right to sell stock at a specific price at a specific date.

There’s a lot of terminology (and math) involved in options, but let’s simplify things down to just what you need to know about call options.

The price at which you can buy the stock is known as the strike price and the future date is called the option’s expiration date. Suppose the strike price is $100. If the stock is trading at $95 (or any price less than the strike price) at expiration, the option is worthless. If the stock price is $105, the option is worth $5 (105-100 = 5). Prior to expiration the difference between the stock price and the strike price is called intrinsic value.

Simply put, you buy calls if you think the underlying asset is going to go up, and you sell calls if you think the underlying asset is going to do down.

Before expiration, options usually trade above intrinsic value. There are two main reasons for this. For one thing the call buyer doesn’t have to pony up the full $105 for the stock like a stock buyer would. Instead the call buyer only pays the price of the option. So the option price must include the interest at the risk-free rate that a stock buyer would forgo by buying the stock. The other component that makes options trade above intrinsic value is the value of the protection afforded by owning a call option. If the stock price declines, the owner of a call can only lose the call premium, while the owner of the stock can lose the full purchase price.

Some traders get bogged down by the option greeks or complicated option strategies, but at the root level, this is what options are.

So a helpful way to think of a call option is just upside participation with borrowed money and built-in downside protection.

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