Let me put a disclaimer out here from the start: Any attempt to have call options explained is not easy, and it normally takes a while (it took me at least a week) to fully grasp the concept of what a call option is, and what it represents. Options are an ever-evolving concept for me, and I’m pretty sure any active options trader will tell you the same thing. There are many different types of options out there (i.e., American style options, European style options, LEAP’s, etc.) and each one would require its own website worth of information to grasp each individual concept. In addition, there’s a whole mathematical side of options trading that completely confuses the heck out of me (like how the Black and Scholes model works), and I don’t claim to understand the extremely complicated equations that explain option decay, option price movement, and so forth. I’m much more of a simple kind of guy, so I was always very appreciative whenever I found any kind of information on the Web that explained options in “layman’s terms”, so to speak. So I’m not going to delve into any deep theories about options pricing models or anything like that; I’m simply going to explain what a call option is from a very top-level, 30,000-foot-view type of perspective. Keep in mind that I’ve really only traded stock options and commodity (or futures) options, so that’s the main thing I’m going to discuss here, but for ease of explanation, I’ll just narrow it down to stock options. An option, whether it’s a call option or a put option, is a contract that basically gives you the right, but not the obligation, to buy a block of shares of a stock at a fixed price within a fixed time period. That already sounds a little convoluted…see, I told you that it may take a few days to sink in. Think about it this way…if you were at a department store and you wanted to buy a DVD player that was on sale, but then you found out that the last one was sold before you had a chance to get to it, most stores will allow you to create a raincheck for that item. Meaning, once they get the DVD player back in stock, even if it’s way after the sale is over, you still have the right to buy the DVD player at its sale price, because you basically “staked your claim” while the item was on sale. Now you’re not obligated to buy the DVD player even though you have a right to buy it; this is the same principle at work with call options. For example, if you bought a call option for Wal-Mart’s stock (ticker: WMT), you would now have the right to buy 100 shares of Wal-Mart stock at a fixed price that you choose (otherwise known as the “strike price”).

The whole point of buying call options is that you expect the price to rise in the relatively near future. So if Wal-Mart was trading at $50.00 per share, you might want to buy a call option with a strike price of $50.00, and if the price of Wal-Mart does indeed rise, you are now making a profit on your call option. Somebody might ask “Well, if that’s the case, why not buy the Wal-Mart stock outright instead of just buying a call option?” There’s a big difference in price between 100 shares of Wal-Mart stock and a call option representing 100 shares of Wal-Mart stock. If you bought the stock outright, you’re looking at a total cost of around $5,000, but if you bought an option on that same amount of stock (and by the way, every option contract represents 100 shares of stock), you would only be laying out a fraction of that price. For instance, as of this writing, with Wal-Mart trading at about $51.00 per share, a call option with a $50.00 strike price (closest expiration month) is going for about $155.00 right now. Another HUGE benefit of buying call options is the fact that you have limited risk; with buying options, you can never lose more than your initial investment. That’s the most you can lose, so you know your total risk level right off the bat. This comes in handy especially in the futures markets, where if you were to trade a futures contract, you could literally lose more than you invested to begin with. But anyway, back to my call option example…once you buy the option, your risk is set, and you now have the right to buy Wal-Mart stock at $50.00 per share, no matter how high the stock’s price goes. If Wal-Mart shares were to have a major spike in price and shot up to $80.00 per share, you still have the right to buy it at $50.00 per share. So, in this example, you would do what’s known as “exercising your option”, giving you the right to enter into a position where you purchase 100 shares of Wal-Mart stock for $50.00 a share, even though the market is currently trading at $80.00 per share, meaning you have a $30.00 per share profit right off the bat. Multiply that times the 100 shares that the option represents, and you now are sitting nice and pretty with a $3,000 profit! It’s a great way to manage the volatility of stock prices without seeing your trading account fluctuate up and down with the price movements, plus it greatly reduces your overall capital at risk. Some people will do what’s known as buying “out-of-the-money” call options, meaning call options with strike prices that are well above the current market price. For example, if you were to buy a call option on WMT with a strike price of $70.00, even though Wal-Mart is trading at $50.00 a share, it would be a very cheap option, because “out-of-the-money” option prices (also known as “premiums”) are based on the probability of whether or not the stock will ever actually hit that price. So, a $70.00 call option on a stock that’s currently trading at $50.00 a share will be really cheap. But if WMT were to have a dramatic and quick spike in price, and it jumped up to $75.00 a share, your call option is now “in-the-money”, because the stock’s price is higher than your strike price, and you would be sitting with a pretty nice profit on your option. You don’t even have to exercise your option to make a profit on it; the options themselves will increase in value along with the stock’s increase in value. There are many cases where people have bought options for no more than $25.00 or $50.00, and they ended up being worth hundreds of dollars or more when dramatic price movements in the underlying stock happened. Whoa, I just checked my word count on this hub, and it’s ridiculous. I’m realizing even as I write this that there’s really not a “simple” way to explain options. Nonetheless, I hope this hub on call options explained has at least begun to bring some clarity to this detailed area of investing.