What Is a Call Option? A Beginner's Guide to Buying Calls

Education December 11, 2014 Spicer Matthews

A call option is a contract that gives you the right, but not the obligation, to buy an asset at a specific price within a set time period. Call options are one of the two basic types of options (the other being put options), and understanding them is essential for anyone looking to trade options.

In this guide, I'll explain call options using a simple real-world analogy, then show you how they work with actual stock examples. By the end, you'll understand when and why traders buy call options—and the risks involved.

Understanding Call Options: The Tractor Analogy

Let's imagine that I have a tractor I am offering for sale for $20,000—which is a smoking deal because the same tractor is selling elsewhere for $25,000. My neighbor realizes that I am unaware of the fair market price and concludes that my tractor would be a good investment for him. What's more, he has come into an inheritance—but he has to wait 6 months to get the money while the courts probate the will. Because he doesn't want to lose this auspicious opportunity, he asks if I would sell him a call option.

A call option is just a fancy term for a contract related to buying an asset in the future at a predetermined price. My neighbor offers me $1,000 to take the tractor off the market and hold it for him until he is ready to buy it in 6 months. This $1,000 does not apply to the cost of the tractor—he still has to pay me $20,000 at the time of the sale. If he does not exercise his option to buy, I keep the $1,000 and can sell the tractor to someone else.

In options trading terminology:

The $1,000 payment is called the premium
The $20,000 purchase price is called the strike price
The 6-month deadline is called the expiration date
The tractor is called the underlying asset

How Call Options Work with Stocks

In the stock market, call options work the same way. When you buy a call option on a stock like Apple (AAPL), you're paying a premium for the right to buy 100 shares at a specific strike price before the expiration date.

For example, let's say Apple stock is trading at $150 per share. You could buy a call option with:

Strike price: $155
Expiration: 30 days from now
Premium: $3.00 per share ($300 total, since each contract controls 100 shares)

This gives you the right to buy 100 shares of Apple at $155, no matter how high the stock price goes. If Apple rises to $170 before expiration, you could exercise your option to buy at $155 and immediately sell at $170—a profit of $15 per share, minus the $3 premium you paid.

Why Do Traders Buy Call Options?

There are several reasons traders buy call options:

1. Leverage

Call options allow you to control a large amount of stock with a small investment. Instead of spending $15,000 to buy 100 shares of a $150 stock, you might spend only $300-500 on a call option. If the stock moves up significantly, your percentage return on the option far exceeds what you'd earn owning the shares outright.

2. Limited Risk

When you buy a call option, the most you can lose is the premium you paid. If the stock drops 50%, you only lose your premium—not the thousands you would have lost owning the shares directly.

3. Speculation

If you believe a stock is going to rise but don't want to commit significant capital, call options provide a way to profit from that belief with limited downside.

Call Options Carry Risk

While buying call options limits your maximum loss to the premium paid, they're still risky investments. Let's revisit our tractor example to understand why.

After selling the call option, I might discover that my tractor is really worth $25,000. Worse, perhaps demand goes up and 6 months from now my tractor is worth $30,000. Because I sold my neighbor the call option, I am contractually obligated to hold onto the tractor and sell it to him for $20,000—and he could turn around and sell the tractor to someone else for a $9,000 profit (minus the $1,000 premium he paid).

But that scenario is not the only possible outcome. The tractor could lose value over those 6 months. Maybe a serious defect is discovered in this model and as a result the tractor's market value drops to $15,000. My neighbor might decide not to buy the tractor from me because he can buy it from someone else for $15,000 rather than the $20,000 he agreed to pay me. In this case, my neighbor loses his entire $1,000 premium, and the option expires worthless.

The Time Decay Factor

One crucial risk with call options is time decay. Options lose value as they approach expiration, even if the stock price stays the same. This is because there's less time for the stock to move in your favor. Experienced traders factor in time decay when deciding which options to buy and when to sell them.

Call Option Example: Profitable Trade

Let's walk through a profitable call option trade:

You buy a call option on XYZ stock with a $50 strike price for $2.00 per share ($200 total)
XYZ stock is currently trading at $48
Over the next few weeks, XYZ rises to $58
Your call option is now worth at least $8 ($58 - $50 strike), or $800 per contract
You sell the option for $800, making a profit of $600 (a 300% return on your $200 investment)

Call Option Example: Losing Trade

Now let's see how a call option trade can go wrong:

You buy a call option on XYZ stock with a $50 strike price for $2.00 per share ($200 total)
XYZ stock is currently trading at $48
XYZ drops to $45 and stays there until expiration
Your call option expires worthless because XYZ never rose above $50
You lose your entire $200 premium—a 100% loss

This illustrates why call options are considered speculative: you can achieve outsized gains, but you can also lose 100% of your investment if the stock doesn't move in your favor.

Key Terms for Call Option Traders

Here are the essential terms you need to know:

In the money (ITM): When the stock price is above the strike price. These options have intrinsic value.
Out of the money (OTM): When the stock price is below the strike price. These options are cheaper but riskier.
At the money (ATM): When the stock price equals the strike price.
Intrinsic value: The amount an option is in the money.
Time value: The portion of the premium that reflects time remaining until expiration.
Exercise: Using your right to buy the stock at the strike price.

Should You Trade Call Options?

Call options can be powerful tools for traders who understand them, but they're not for everyone. Here are some things to consider:

Start with education: Before trading real money, make sure you thoroughly understand how options work, including the Greeks (delta, theta, etc.) that affect option prices.
Paper trade first: Many brokers offer paper trading accounts where you can practice with fake money.
Manage risk: Never invest more in options than you can afford to lose completely.
Consider other strategies: While buying calls is straightforward, there are many other options strategies that may better suit your goals and risk tolerance.

Next Steps

Now that you understand call options, here are some related topics to explore:

What Is a Put Option? - Learn about the other fundamental option type
What Is a Put Credit Spread? - Discover a popular income-generating strategy
How Does Volatility Affect Option Prices? - Understand this crucial factor

Options trading can be complex, but by starting with the basics and building your knowledge step by step, you can learn to use options effectively as part of your trading strategy.

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