If you’ve heard about call options, and you’re wondering exactly what they are and what they allow you to do, you’re in the right place.
The truth about call options is they’re actually quite easy to understand. Options are just contracts between two people — a buyer and a seller. There are two types of options — call options and put options. Despite the many complex-sounding strategies you may have heard of, they’re all created from just calls and puts. So if you can understand calls and puts, you can understand any options strategy.
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Call options and put options: The technical stuff
What long call options do:
Call options give the buyer the right but not the obligation to buy shares of stock for a fixed price over a given time.
What long call options don’t do:
Force you to purchase shares of a stock.
It’s important to understand buying call options give you the right to buy shares. It’s a right — when you buy a call, you’re never obligated to buy shares of stock. Call options get their name because you’re calling shares away from another trader — the one who sold you the call. In other words, you’re choosing to be the buyer.
What long put options do:
Put options (opposite call options), give the buyer the right (but not the obligation) to sell shares of stock for a fixed price over a fixed period of time.
What long put options don’t do:
Force you to sell shares of a stock.
Just like with call options, put options offer a right, but not an obligation. Notice that the definitions for call options and put options are nearly identical. It’s just that calls allow you to buy shares while puts allow you to sell shares. Put options get their name because you’re putting shares back to another trader — the one who sold you the put option. It’s as if you’re saying, “I don’t want my shares anymore. Here, you take ‘em. I’m putting them back over to you.” In other words, you’re choosing to be the seller.
At their very core, options are just contracts representing rights to either buy or sell shares of stock.
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Struggling to understand? Think of options like coupons
If hearing options explained in a technical way is sending you for a spin — that’s okay. Don’t give up. You just need it explained in the right way! Let’s try this:
I bet you’ve used something extremely similar to a call option before. Think about a pizza coupon. If you can understand how a pizza coupon works, then you understand how a call option works. Sounds crazy right? Watch this.
First, if you’re in possession of a pizza coupon, you’re never required to use it. Just like call options, the pizza coupon represents a right but not an obligation to buy. In fact, that’s where options get their name. It’s your “option” to choose whether to use your contract or not.
But if you do decide to use this coupon, it spells out exactly what you can buy. In this example, it’s the right to buy one large pizza. Not two, not three, not two medium pizzas — one large pizza. In a similar way, an option allows you to buy one hundred shares of a particular stock. Not 125. Not 99. 100 shares.
Next, the coupon states what your purchase price will be. Here, it’s $10 dollars. No matter what the menu price is, when you get to the restaurant, you know for sure your price will be ten dollars.
And finally, you can only use this coupon for a limited time. There’s an expiration date.
Easy, right? This is exactly how call options work. For instance, imagine you buy a Microsoft, May, $300-strike call.
You have the right to buy 100 shares of Microsoft.
And your share price is guaranteed for this fixed $300 dollars, no matter how high the share price may be at that time.
And finally, there’s only so long that you can use this call. Just like pizza coupons, there is an expiration date. For most options, the last trading day is the third Friday of the expiration month. So in this example, you’d have any time through the third Friday in may to 100 shares of Microsoft with this call option. After that, it expires — just like the pizza coupon.
Now here’s another question: If options are just the right to buy or sell 100 shares of stock, what makes them so powerful?
Why people trade options
The most important thing to know about options is that they provide leverage. Which just means that if the stock rises 1%, your contract will rise by a greater percentage. Second, options are more cash efficient than shares. So they allow you to spread your money thinner over far more investments. That gives you a better chance for success. And finally, options allow you to hedge, roll, and morph positions as market conditions change.
These things are just not possible with shares of stock. So if you’re finding the current market conditions too volatile, you can tame the uncertainty by using options. And it all begins by taking the time to understand the two basic building blocks: calls and puts.
If you have questions, or want to learn more about why options are such powerful tools, our blog has a wealth of free education and trade ideas available 24/7.
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