The main advantage of buying a call option as opposed to buying the underlying stock is

Selling a call option to open a trade means taking the other side of a long call transaction - selling to open (short call) instead of buying to open (long call). For every long call, there’s a short one – together, these form a contract that stipulates the agreement to exchange the underlying at a predetermined price by the expiration date. 

Contrary to long calls, the market assumption in a short call position is typically bearish. Sellers of call options either expect the underlying’s market price to drop or remain neutral. As long as the option remains OTM or above the stock price at expiration, the seller gets to keep the premium received without having to exchange the underlying. 

As stated above, being short a call option doesn’t mean you’re automatically short 100 shares of stock if the stock price rises above the short call. As long as there’s substantial extrinsic value remaining in the option, assignment risk is low, since the call buyer would be giving that value up to obtain the shares (which doesn’t make sense in most cases outside of collecting a dividend payment).

If a long call buyer exercises their right to convert the call to 100 shares of the underlying, the seller is obligated, through assignment, to make the exchange. In this case, the seller typically incurs a loss, as buyers usually exercise a long call that has already moved ITM, but the short call holder would still have 100 short shares as an active trade.

Imagine you are the seller in the long call example.

Despite XYZ rolling out a new product, you don’t think that the share price of $2,800 will rise. In fact, you’re expecting a pullback, especially since the launch of the new product is being met with a lot of criticism, with questions about usefulness and practicality.

You attempt to capitalize on the skepticism around the product release, shorting one call option at a strike price of $2950.00. You collect a premium of $10 per share for selling the call, which adds up to $1,000 in real dollar terms since you assume 100 shares of short stock risk when selling a call.

After some initial movement in both directions, the stock ends up trading below the strike price of $2,950 by the expiration date of your contract. Since this results in the option expiring OTM and worthless, you realize a profit of $1,000, the premium received from assuming the risk of 100 short shares above $2950. This amount excludes any additional costs such as commission and regulatory fees.

Prior to expiration, options will still fluctuate in value as the market moves. Even if the stock doesn’t reach $2950 in this case, you may still see an unrealized loss, if the option is trading for more than $10.00 which is what you sold it for. 

Let’s assume the day after you sold the option, the stock rallied from $2800 to $2850. Maybe your option is now worth $12.00, which would mean you’d see an unrealized loss of $200, even though the option would still be worthless at expiration as it’s OTM. Keep this in mind with short and long options trades. 

At expiration, the result of short options trading is pretty binary – you either keep the credit received from selling the option if it expires OTM and realize that as profit, or if the strike is ITM at expiration the option will be worth the equivalent of how far ITM it is.

For example, if the stock is at $2965 in this example, it would be worth $15.00 or $1500 in real dollar terms since the option would be $15 points ITM. You collected $10.00 upfront though, so the realized loss from closing the position would be $5 or $500 in real dollar terms.

If you did not close the position and let it expire ITM, the short call would convert to 100 short shares of stock at $2950 and you would still keep the premium received up front.

To avoid assignment or taking shares at expiration, you can roll the short call further out in time, or close the contract to end the trade.

As a long option holder, you need the stock price to rise above the strike by more than what you paid for the option to realize a profit.

With short options trades, you can absorb movement above your strike, equivalent to the credit received from selling the option before you reach your breakeven price.

When people talk about options or options trading, they're usually referring to strategies that involve buying and selling two types of options, calls and puts.

This article provides an overview of why investors buy and sell call options on a stock, and how doing so compares to owning the stock directly.

🤓Nerdy Tip

The basic question in an options trade is: What will a stock be worth at some future date? Buying a call option is a bet on “more.” Selling a call option is a bet on “same or less.”

What is a call option?

Options are a type of financial instrument known as a derivative because their value is derived from another security, or underlying asset. Here we discuss stock options, where the underlying asset is a stock.

A call option is a contract that gives the owner the option, but not the requirement, to buy a specific underlying stock at a predetermined price (known as the “strike price”) within a certain time period (or “expiration”).

For this option to buy the stock, the call buyer pays a “premium” per share to the call seller.

Each contract represents 100 shares of the underlying stock. Investors don’t have to own the underlying stock to buy or sell a call.

If you think the market price of the underlying stock will rise, you can consider buying a call option compared to buying the stock outright. If you think the market price of the underlying stock will stay flat, trade sideways, or go down, you can consider selling or “writing” a call option.

For a call buyer, if the market price of the underlying stock price moves in your favor, you can choose to “exercise” the call option or buy the underlying stock at the strike price. American options allow the holder to exercise the option at any point up to the expiration date. European options can only be exercised on the date of expiration.

Buying and selling call options can also be used as part of more complex option strategies.

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Buying a call option

Buying calls, or having a long call position, feels a lot like wagering. It allows traders to pay a relatively small amount of money upfront to enjoy, for a limited time, the upside on a larger number of shares than they’d be able to buy with the same cash. Call buyers generally expect the underlying stock to rise significantly, and buying a call option can provide greater potential profit than owning the stock outright.

If the stock's market price rises above the strike price, the option is considered to be “in the money.” An in the money call option has “intrinsic value” because the market price of the stock is greater than the strike price. The buyer has two choices: First, the buyer could call the stock from the call seller, exercising the option and paying the strike price. The buyer takes ownership of the stock and can continue to hold it or sell it in the market and realize the gain. Second, the buyer could sell the option before expiration and take profits.

When the stock trades at the strike price, the call option is “at the money.”

If the stock trades below the strike price, the call is “out of the money” and the option expires worthless. Then the call seller keeps the premium paid for the call while the buyer loses the entire investment.

Let’s look at an example. XYZ stock is trading for $50 a share. Calls with a strike price of $50 are available for a $5 premium and expire in six months. In total, one call contract costs $500 ($5 premium x 100 shares).

The graph below shows the buyer’s profit or payoff on the call with the stock at various prices.

Because one contract represents 100 shares, for every $1 increase in the stock price above the strike price, the total value of the option increases by $100.

The breakeven point — above which the option starts to earn money, have intrinsic value or be in the money — is $55 per share. That’s the strike price of $50 plus the $5 cost of the call. When the stock trades between $50 and $55, the buyer would recoup some of the initial investment, but the option does not show a net profit.

When the option is in the money or above the breakeven point, the option value or upside is unlimited because the stock price could continue to climb.

If the stock trades below the strike price, the option is out of the money and becomes worthless. Then the option value flatlines, capping the investor’s maximum loss at the initial outlay of $500.

Buying a call option vs. owning the stock

Buying call options can be attractive if an investor thinks a stock is poised to rise. It’s one of two main ways to wager on a stock’s increase. The other way is by owning the stock directly. Buying calls can be more profitable than owning stock outright.

Let’s look at an example to compare the outcomes for investors of the two call strategies with owning the stock directly.

XYZ stock trades at $50 per share. Call options with a $50 strike price are available for a $5 premium and expire in six months. Each options contract represents 100 shares, so 1 call contract costs $500. The investor has $500 in cash, which would allow either the purchase of one call contract or 10 shares of the $50 stock.

Here’s how the payoff profile would look at expiration for stockholders, call buyers and call sellers.

Stock price at expiration

Price movement

Stockholder's profit/loss

Call buyer's profit/loss

Call seller's profit/loss

The attraction to buy calls the more the stock price rises is obvious. If the stock moves up 40% to $70 per share, a stockholder would earn $200 ($70 market price - $50 purchase price = $20 gain per share x 10 shares = $200 in total profit). However, owning the call option magnifies that gain to $1,500 ($70 market price - $50 strike price = $20 gain per share. $20 - $5 cost of the contract = $15 gain per share x 100 shares = $1,500 in profit).

If the stock price moves up significantly, buying a call option offers much better profits than owning the stock. To realize a net profit on the option, the stock has to move above the strike price, by enough to offset the premium paid to the call seller. In the above example, the call breaks even at $55 per share.

The entire investment is lost for the option holder if the stock doesn’t rise above the strike price. However, a call buyer’s loss is capped at the initial investment. In this example, the call buyer never loses more than $500 no matter how low the stock falls.

For the stockholder, if the stock price is flat or goes down, the loss is less than that of the option holder. Owning the stock directly also gives the investor the opportunity to wait indefinitely for the stock to change direction. That’s a significant benefit over options, whose life expires on a specific date in the future. With options, not only do you have to predict the stock’s direction, but you have to get the timing right, too.

Selling a call option

Call sellers (writers) have an obligation to sell the underlying stock at the strike price and have a “short call position.” The call seller must have one of these three things: the stock, enough cash to buy the stock, or the margin capacity to deliver the stock to the call buyer. Call sellers generally expect the price of the underlying stock to remain flat or move lower.

If the stock trades above the strike price, the option is considered to be in the money and will be exercised. The call seller will have to deliver the stock at the strike, receiving cash for the sale.

If the stock stays at the strike price or dips below it, the call option usually will not be exercised, and the call seller keeps the entire premium. But on rare occasions, the call buyer still might decide to exercise the option, so the stock would have to be delivered. This situation benefits the call seller, though, since the stock would be cheaper than the strike price being paid for it.

Let’s look at an example. XYZ is trading for $50 a share. Calls with a strike price of $50 can be sold for a $5 premium and expire in six months. In total, one call contract sells for $500 ($5 premium x 100 shares).

The graph below shows the seller’s payoff on the call with the stock at various prices.

Since each contract represents 100 shares, for every $1 increase in the stock above the strike price, the option’s cost to the seller increases by $100. The breakeven point of the call is $55 per share, or the strike price plus the cost of the call. Above that point, the call seller begins to lose money overall, and the potential losses are uncapped. If the stock trades between $50 and $55, the seller retains some but not all of the premium. If the stock trades below the strike price, the option value flatlines, capping the seller’s maximum gain at $500.

At most, call sellers can receive the contract premium — $500 — but they have to be able to deliver the stock at the strike price if the stock is called by the buyer. Potential losses theoretically are infinite if the stock price continued to rise, so call sellers could lose more money than they received from their initial position.

Selling calls can be dicey, but there is a popular and relatively safe way to do it via covered calls, which limits the unlimited liability of a “naked” call option discussed above, where the seller sells the call without also owning the underlying stock.

Why call options can make sense

Call options are popular because they can allow investors to achieve different means. One lure for investors wanting to speculate is that they can magnify the effects of stock movements, as the table above indicates. But options have many other uses, such as:

Limit risk-taking, while generating a capital gain. Options often are seen as risky, but they can also be used to limit risk or hedge a position. For example, an investor looking to profit from the rise of XYZ stock could buy just one call contract and limit the total downside to $500, whereas for a similar gain a stockholder’s much larger investment would be wholly at risk. Both strategies have a similar payoff, but the call limits potential losses.

Generate income from the premium. Investors can sell call options to generate income, and this can be a reasonable approach when done in moderation, such as through a safe trading strategy like covered calls. Especially in a flat or slightly down market, where the stock is not likely to be called, it can be an attractive prospect to generate incremental returns.

Realize more attractive selling prices for their stocks. Some investors use call options to achieve better selling prices on their stocks. They can sell calls on a stock they’d like to divest that is too cheap at the current price. If the price rises above the call’s strike, they can sell the stock and take the premium as a bonus on their sale. If the stock remains below the strike, they can keep the premium and try the strategy again.

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