What Are Call Options and How Do They Work?

When looking for a smart investment strategy, some investors buy call options. Call options often enable investors to maximize profits while minimizing risk. Purchasing a call option may yield profit that is significantly higher than if you bought a security outright. Understanding call options and how they work can help investors make savvy investment decisions. Here’s how to determine if this investment strategy is right for you.

A financial advisor can walk you through different investment options that fit your budget and long-term goals.

What Are Call Options?

Call options give investors the opportunity, but not the obligation, to purchase a stock, bond, commodity or other security at a certain price, within a specific time frame. The sellers must let the buyers exercise this option. The buyer of a call option must pay a premium for the privilege of having the choice to buy the security at a predetermined “strike price” on or before a specific date.

It makes sense for an investor to buy a call option if the stock price rises above the price in the option. This means that the investor is able to buy the stock at a discount. On the other hand, if the stock price dips below the option price, it may not make sense for the investor to buy.

The main reason an investor would want to buy a call option is to capitalize on the upside of owning a stock while minimizing the risk. For instance, if you had the opportunity to either buy 100 shares of stock for $60 per share or a call option and purchase the stock at a discount, wouldn’t it make more sense to do the latter? That’s what many investors did in 2021 with short-squeezed stocks on Reddit’s WallStreetBets.

Characteristics of Call Options

When selecting a call option, you have several decisions to make before purchasing one. Understanding the elements of call options is crucial when deciding if they are a suitable investment strategy for you. Here are eight options you can choose from:

Security. If you think a particular security is going to increase in value in the near future, you may want to buy a call option.
Trade amount. The trade amount is the maximum amount you want to spend on a call option transaction.
Number of contracts. When you buy a call option, you will need to decide the number of shares you would like to purchase.
Strike price. Regardless of what the current stock price is, an owner of a call option can decide at what strike price they want to purchase the security. For example, if they want to purchase ABC stock for $60 per share, the call option is only exercised when the stock price reaches that amount.
Call options price. The purchase of call options involves a premium amount for completing the trading transaction. If the premium is $2 per share and the call option is for 100 shares at $60, the investor would pay a $200 premium for this transaction.
Expiration date. Investors have the choice to select an expiration date for the contract. This means that if the price doesn’t hit their call option amount by the selected date, the request expires.
Type of order. Investors can also select a type of trading order. For example, an investor can select a limit order, which allows the investor to buy or sell a stock at a certain price.
Put option. The opposite of a call option, a put option is where investors place an order to sell their shares at a certain price within a certain time frame.

How Call Options Work

To illustrate how a call option works, let’s use the example above. If a stock is trading at $60 per share, you may predict that the price will rise in the near future. While you could purchase 100 shares by paying $6,000, you could also buy a call option that would allow you to buy the stock at $63 per share within the next two months. This option could cost an investor a premium of $1.75 per share or $175, based on current market trends.

If your prediction is correct, and the stock price rises to say $83 per share, then both investment strategies may result in a similar outcome. The first strategy, to purchase the stock outright, would mean your investment would be worth $8,300. This outcome yields a profit of $2,300. The other strategy, to buy the call option at $63 per share, would result in a $2,000 profit. You’d need to subtract the $175 premium to determine your gross profit from the call option investment.

However, if the stock price skyrocketed, to say $103 per share, an investor could make upward of $4,000, minus the option premium for the transaction. If the investor didn’t purchase the stock when it was at a lower price, they may have missed their opportunity to profit. Therefore, the stock option allowed them to capitalize on the rising price of the stock.

You can purchase a call option through an online brokerage account or on a variety of exchanges. However, you must first be approved, which is based on the level of experience and amount of knowledge with options trading.

Disadvantages

The downside of buying a call option is if the stock price only increases a bit, you could actually lose money on the investment. For example, if the stock price from the example above only rose to $63, and you bought 100 shares outright, you would profit $300. If you bought a call option of $63 per share you would make the same $300, but lose $175, which was the cost of the premium associated with buying the call option. This means you’d really only profit $125. This is exactly what happened with many Gamestop andAMC call options. After making big gains in January 2021, the stock price slid significantly.

However, the real value of call options is to minimize the risk of an investment. If you were to buy a call option and the stock price went down, you would save yourself from losing money. If you bought the stock outright for $60 per share, and the price dropped to $40 per share, you would lose $2,000. Purchasing the call option would only cause you to lose $175. The risk of the call option is always capped at the price of the premium. So even if the stock price doesn’t rise at all, you may still need to pay the premium, which technically means you’d lose money.

When a Call Option Makes Sense (and When It Doesn’t)

A call option may make sense when an investor has a bullish outlook on a stock and expects its price to rise within a defined time period. Instead of committing a large amount of capital to buy shares outright, the investor can use a call option to gain exposure to potential upside with a smaller initial outlay. This approach is often used when an investor wants leveraged exposure without tying up significant cash.

Call options can also be useful when an investor expects a specific event to move a stock’s price, such as an earnings report, product launch or regulatory decision. In these situations, the investor is not only predicting direction, but also timing. Because options expire, the stock must move in the expected direction before the expiration date for the strategy to work.

A call option may be less suitable when an investor has a long-term buy-and-hold outlook. If the goal is to own a stock for years and collect dividends, purchasing shares directly may be simpler. Call options do not provide ownership rights, voting power or dividend income, and repeated option purchases can increase transaction costs over time.

Risk tolerance also plays a role. While the maximum loss on a call option is limited to the premium paid, it is still possible to lose 100% of that amount. Investors who prefer lower-volatility strategies or more predictable outcomes may find traditional stock or bond investments more consistent with their approach.

Before using call options, investors often consider their time horizon, market outlook, and comfort with short-term price swings. Matching the strategy to these factors helps determine whether a call option fits within an overall investment plan.

Bottom Line

While call options may seem like a savvy investment choice, all investment strategies have a different level of risk and reward. Investors should consider each type of investment before determining which decisions make sense and align with their goals.

Tips for Investors

A financial advisor can help you evaluate your investment objectives and aid you in the creation of your own investment strategy. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
While investing your money is an exciting way to potentially grow it, it’s important to ensure your other finances are in order. Before investing, consider building an emergency fund with at least six months’ worth of expenses saved. Also, consider reevaluating your retirement saving strategy to ensure you’re all set for your future. Lastly, don’t forget to pay down your debt to save even more money in the long run.