Call Options

A call option is a financial contract that gives the buyer the right, but not the obligation, to purchase an underlying asset—most commonly 100 shares of a stock—at a specified price on or before a specific date. Think of it like putting a non-refundable deposit on a house you like. You pay a small fee today to lock in the right to buy the house at today's price in three months. If house prices in the neighborhood skyrocket, you've got a fantastic deal. If they plummet, you can walk away, losing only your deposit. In the world of stocks, this “deposit” is called the premium, the locked-in purchase price is the strike price, and the deadline is the expiration date. For this right, the option buyer pays a premium to the option seller. This simple mechanism creates a world of possibilities, from high-stakes speculation to conservative income generation.

Understanding call options is all about understanding the two sides of the contract: the buyer and the seller. Their goals and risk profiles are mirror opposites.

You buy a call option when you are bullish on a stock; you believe its price is going to rise significantly. Your potential profit is theoretically unlimited, while your maximum loss is capped at the premium you paid for the option. Let's imagine you're sweet on “Buzz Cola Corp.” (Ticker: BUZZ), currently trading at $48 per share. You believe good news is coming, so you buy one call option contract with:

• Strike Price: $50
• Expiration Date: 3 months from now
• Premium: $3 per share (total cost = $3 x 100 shares = $300)

Your break-even price for the stock is $53 ($50 strike price + $3 premium). Here are two possible outcomes:

1. Scenario 1: You're right! BUZZ announces a new celebrity endorsement, and the stock soars to $60 before your option expires. Your option is now in the money. You can exercise your right to buy 100 shares at $50 and immediately sell them at the market price of $60.
   • Your profit: ($60 - $50) - $3 premium = $7 per share.
   • Total Profit: $7 x 100 shares = $700. A handsome return on your $300 investment.
2. Scenario 2: You're wrong. The news is a dud, and BUZZ stock stagnates at $48. Your option is worthless at expiration because no one would use a contract to buy a stock for $50 when it's available on the open market for $48.
   • Your loss: The $300 premium you paid. That's it. Your risk was defined from the start.

You sell (or “write”) a call option when you are neutral or bearish on a stock. You believe its price will stay flat or fall, and you're happy to collect the premium as income. Using our BUZZ Cola example, you are the one who sold the call option and collected the $300 premium.

1. Scenario 1: You're right. The stock price stays below $50. The option expires worthless, the buyer doesn't exercise it, and you simply keep the $300 premium. This is your maximum profit. Easy money!
2. Scenario 2: You're wrong. The stock shoots to $60. The buyer exercises the option, forcing you to sell them 100 shares of BUZZ at $50 each.
   • If you already own 100 shares of BUZZ (this is called a covered call), you miss out on the extra upside between $50 and $60, but you still sold your shares at a price you deemed acceptable and pocketed the $300 premium. It's a conservative strategy to generate income.
   • If you don't own the shares (a naked call), you are in big trouble. You must now go to the open market, buy 100 shares at $60 each, and immediately sell them to the option buyer for $50 each. You lose $10 per share, minus the $3 premium you received. Your net loss is $700. Since a stock's price can theoretically rise infinitely, the risk on a naked call is unlimited.

For disciples of value investing, options are often viewed with a healthy dose of skepticism, and for good reason. Legends like Warren Buffett have famously described derivatives as “financial weapons of mass destruction.”

Buying call options is the quintessential act of speculation. It's a bet on a stock's price movement over a short period, not an investment in the underlying business's long-term intrinsic value. The value investor buys a piece of a wonderful business at a fair price, intending to hold it for years. The call option buyer is betting on market sentiment and timing. Furthermore, every option has a hidden enemy: time decay (also known as “theta”). Like a melting ice cube, an option loses value every single day that passes, even if the stock price goes nowhere. This relentless decay is a powerful headwind against the option buyer, making it a difficult game to win consistently.

While buying calls is speculative, selling them can fit neatly into a value investor's toolkit. The covered call strategy described earlier is a perfect example. Imagine you own a stock you bought at a great price. It has since risen to what you believe is its fair value. You wouldn't mind selling it at this price, but you also wouldn't mind holding it for more dividends. By selling a covered call, you can:

• Generate extra income: The premium you collect is an immediate boost to your return.
• Set a target selling price: You effectively agree to sell your shares at the strike price if the stock rises, a price you are already happy with.

This strategy doesn't aim for spectacular home runs. Instead, it's a conservative way to squeeze a little more juice from the assets you already own, which is a mindset Benjamin Graham himself would appreciate.

• Call options give the owner the right to buy an asset at a set price.
• Buyers are bullish. They have limited risk (the premium paid) and a high potential for reward.
• Sellers are neutral-to-bearish. They have limited reward (the premium received) but can face unlimited risk if they sell “naked” calls.
• For the average value investor, buying calls is a speculative gamble due to time decay and the focus on short-term price moves.
• Selling covered calls on stocks you already own can be a sensible, conservative strategy to generate additional income.