What Is a Call Option Contract?

Call option contracts confer the right, but not an obligation, to buy shares of a stock (the "underlying security") at a stated price called the "strike price." The call option is good until its expiration date (called the "expiry"). Investors use call option contracts as a way of leveraging stock transactions because they cost far less than the stock itself. That increases the potential return, but also magnifies the risk involved. Most call option contracts follow a standardized format, although some over-the-counter contracts have special features (these are referred to as exotic options). Employee stock options are a form of call option contracts issued by a particular company to employees.

Identification

The call options traded on markets such as the Chicago Board of Options Exchange (CBOE) are standardized contracts for 100 shares of stock. The issuer (called the writer) of the option contract specifies the particular stock, the strike price and expiry and whether the option is a call option or a put option (which gives the buyer the right to sell, rather than buy, the shares of stock). The writer charges a premium and is obligated to sell the shares to the holder of the contract when and if it is exercised. Call option contracts are written for other underlying securities, not just for stocks. For example, you can trade call option contracts on futures, index options whose value is tied to a stock index such as Standard & Poor's 500 and currency options on the foreign exchange market.

Buying Calls

When traders purchase a call option contracts, they pay a premium to the writer (typically this is no more than $1/share). If the stock the contract refers to goes up in price enough to cover the strike price plus the premium, a trader is "in the money" and can exercise the option for a profit. For example, if you buy a call option contract with a strike price of $25/share and pay a premium of $1/share ($1000 for a standard contract), you will be in the money if the stock rises above $26/share. Say the stock goes to $30/share. You exercise the option by paying the strike price of $25/share to the option writer and then sell the shares at $30/share, making a $4/share profit ($5/share minus the premium). In practice, you don't normally put up the cash to buy the stock. Instead, you can carry out a "cashless exercise" in which your broker loans the money to buy the stock, then sells it to get his money back and give you your profit.

Writing Calls

The writer of a call option contract is required to sell the stock if the owner of the contract chooses to exercise the option. When the contract is issued, an option writer buys the shares at or near the strike price. If the option is exercised, the writer delivers those shares, is paid the strike price and keeps the premium as profit. If the stock falls below the strike piece and remains there until the expiry, the option won't be exercised. In that event, the writer still keeps the premium, but is stuck with shares of stock that have declined in value. The option writer can hold the stock, hoping the price will recover. An alternative strategy is to write a new option contract once the old one has expired. The new call option contract will have the lower market price as its strike price. The premium from the sale of the new contract helps offset the loss resulting from the stock's decline.

Risk

Trading call options is potentially very profitable. In the example above (under Buying Calls) the profit---$4 for every $1 invested---amounts to a 400-percent gain. However, the risks are comparable. If you buy a call option contract and the price does not go up before the expiry, the option is worthless and you lose 100 percent of the money you put up. However, your loss is limited to the premium you paid. The option writer assumes that risk (he is the one who will end up holding the shares if the stock price drops). The premiums charged are how an option writer offsets the risk of writing a call option contract.

ESO

Employee stock options (ESO) are similar to other call option contracts, except they are issued by a company only for its own stock and cannot be traded on exchanges. Similar to a traded call option contract, an ESO gives the holder the right to buy shares at a strike price until the option expires, although there is no obligation to do so. Since the ESO is given to employees, there is zero risk on their part---they don't even pay a premium. The company, acting as option writer, assumes the option will be exercised and bears the cost of paying the difference between the strike price and the sale price.