What Is a call option and how can you trade with it?

What is a call option?

A call option grants a buyer the right, but not the obligation, to purchase a stock, bond, commodity or other asset or instrument at a particular price within a predetermined window of time. They can also be used to trade indices.

When the value of the underlying asset rises, the call buyer can make money. A seller of a call option makes money when the value of the underlying asset stays fixed or falls.

How does a call option work?

The holder of a call option, a type of derivative contract, is given the right but not the obligation to buy a certain number of shares at a predetermined price, also known as the 'strike price' of the option.

Buyers of the call pay a premium on the asset to execute the order, which will be received by the call seller.

Option holders may exercise their rights to buy the stock at the strike price. They can then sell it at the higher market price to lock in a profit if the stock's market price increases over the option's strike price by the expiry of the contract.

Call options are leveraged based on their premium. For example, a buyer may purchase 200 shares of a stock at a price of $1 per share. For a premium of $200, the seller could realise huge returns alongside minimal changes in a share's price.

But choices are only valid for a short while. The options expire worthless if the market price does not move higher than the strike price in that timeframe.

Call options are described as 'in the money' when they expire with a value higher than their strike price. They are described as 'out of the money' if the market price is lower than the strike price at the time of expiry.

Long call options vs short call options

There are several ways to trade calls, but the following two strategies are the most common.

Long call option

The long call is the better-known of the call options. It relates to a trader buying a call option. A purchased call option with an open right to purchase shares is referred to as a 'long call'.

The purchaser of a long call position pays for the right to purchase shares of the underlying stock at the strike price, which is less expensive than the underlying stock's market value. This means the option has the potential for growth, provided the stock price of the underlying stock increases.

Short call option

The open obligation to sell shares is known as a 'short call'. The 'short call position' requires the call's seller to sell shares of the underlying stock at the call's strike price up until the expiration date.

This means despite receiving the initial payment for the call (the buyer's premium), a seller may have to pay back the buyer if the underlying asset rises in value.

A trader generates income by receiving a premium if the stock stays fixed or declines. But they face an increase in risk if the underlying asset rises above its strike price.

Pros and cons of call options

Pros of call options

Call options are leveraged based on their premium. Because these call options are leveraged, a trader is able to gain complete market exposure with a relatively minimal capital investment of the premium when purchasing, or of the margin when selling.

In percentage terms, returns from a rising call option are accordingly much higher than the returns if the trader had held that individual stock.

Meanwhile, a trader's losses while purchasing a call option are restricted to the whole premium amount. However, this is only limited to a long call, with risks and potential losses virtually limitless for the seller of a call option in a short call position.

Cons of call options

Options are subject to time decay, which means that as the expiration date draws nearer, the value of an out-of-the-money option contract drops. This occurs as the buyer's time to realise a profit diminishes.

Call options can be costly for novice traders who are unaware of the risks due to their complexity. This is particularly true for sellers of a call option. Due to this, it is crucial for traders to have a risk management plan set up before they begin trading.

Call option examples

Long call option

Imagine you are feeling bullish on Apple stock, and believe it will rise above a strike price of $165 by the expiry date of its contract. Through share dealing, you purchase a call on the stock for $2. A hypothetical option costs $200, equivalent to 100 shares costing $2 each.

For every dollar amount that the stock rises above $165, you receive a $100 return. When the stock rises to $167, your call option breaks even as the premium is repaid. A profit is realised above $167.

In percentage terms, this makes options much more profitable than simply holding Apple shares. While an increase in Apple shares from $165 to $168 represents a 1.8% increase, the buyer of an option would see a 50% return by receiving $100 on top of their $200 premium.

The stock remains out of the money until this point, with the buyer of the contract losing all or some of their premium to the seller.

Short call option

Conversely, suppose you hold Apple stock but are bearish on its future performance, and believe it won't rise above $167 by its expiry date. You offer to sell a call option on 100 Apple shares at $0.37 per share. A hypothetical option here could cost $37 for 100 shares.

If the stock fails to rise above the strike price by expiry, the seller retains the $37 premium on the Apple shares it sold to the buyer. However, the seller is exposed to hypothetically limitless losses if Apple shares soar above the strike price.

How to trade call options

1. Research your preferred market
2. Decide what you want to trade
3. Open an account with us or practise on a free demo
4. Select your opportunity
5. Set your position size and manage your risk
6. Place your deal

You can trade options in a variety of asset classes in the UK. This can be done through forex options – including majors like EUR/USD, GBP/USD, USD/CHF and EUR/GBP. Users of our platform can also trade share options – including FTSE 100 shares and a selection of leading US shares. Stock indices, including the FTSE 100 and Wall Street, as well as commodities like metals and energies, are also popular ways to trade call options.

Trading options via spread betting and CFDs

Open a spread betting or CFD trading account. Then:

1. Speculate on share prices using derivates rather than owning any actual shares
2. Trade on the prices of soft commodity futures markets
3. Trade on price movements in the soft commodity spot ('undated') market

Spread betting has certain advantages. You can choose an amount per point movement using spread bets. This gives you more control over your position size and currency exposure. Spread bets are popular with traders because all your profits are tax free, and there is no stamp duty or commission payable.* All spread bets are leveraged, which means you only pay an initial deposit to open the position. However, overall profits are based on the full position size, not your premium size.

Note that when buying call or put options, your risk is limited to the margin you paid to open the position. If you sell options, your risk is potentially unlimited, so you need to carefully manage your risk.

You can also trade options using CFDs – short for 'contract for difference'. Like spread bets, CFDs are leveraged products. This means you don't own the underlying asset, but you're betting on its price movement. Your currency exposure and initial margin will vary according to the contract of the asset chosen.

Similar to spread bets, buying options using CFDs limit losses to the initial margin paid, and selling options can risk unlimited losses. Your wins or losses will depend on the outcome of your prediction. CFDs are popular with traders because you can offset losses on CFDs against profits for capital gains tax purposes.* Therefore, traders often use CFDs to hedge their positions.

Remember, trading with spread betting or CFDs comes with added risk attached to leverage. Your position will be opened at a fraction of the value of the total position size – meaning you can gain or lose money much faster than you might expect. When share dealing, you buy and own the shares, so you aren't exposed to this risk. However, you'll still need to keep in mind that past performance does not necessarily indicate future returns.

* Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.

Call options summed up

• Call options are a type of derivative contract that sees a trader buy or sell an underlying asset at a predetermined price, known as its strike price
• The most popular ways of trading call options are through a long call option – where you have the right, but not the obligation, to buy shares at a strike price, and a short call option – where you sell a call option to a buyer at a strike price
• Call options are popular because they offer huge leverage above what a trader could normally afford. But, this also means traders can fail to realise the risk and expose themselves to big losses
• You can use call options to trade several asset classes, including the forex, shares, stock indices and commodities