Calls

A call option, or simply a “call,” is a financial contract that gives its buyer the right, but crucially, not the obligation, to purchase an underlying asset—like a stock—at a predetermined price on or before a specific date. Think of it as putting down a non-refundable deposit to lock in the purchase price of something you believe will become more valuable soon. If the price skyrockets, you can exercise your right to buy at your locked-in lower price for a potential profit. If the price falls, you can simply walk away, losing only your initial “deposit.” While this sounds appealing, calls are complex instruments with a ticking clock. Their value can evaporate quickly due to time decay, making them a favorite tool for short-term speculation rather than long-term investment. For the disciplined value investor, who focuses on owning great businesses for the long haul, calls are often viewed as a dangerous distraction from the real work of analyzing companies.

Imagine a classic car enthusiast, Alice, finds a vintage Mustang for sale for $50,000. She's convinced a Hollywood movie featuring the car is about to be announced, which would cause its value to soar. However, she doesn't have the full $50,000 right now. She strikes a deal with the seller, Bob. Alice pays Bob a non-refundable fee of $2,000 for the exclusive right to buy the car for $50,000 anytime in the next three months. In this analogy:

• The call option is the agreement they signed.
• The underlying asset is the Mustang.
• The strike price is $50,000.
• The premium is the $2,000 fee Alice paid.
• The expiration date is three months from now.

If the movie news breaks and the car's market value jumps to $80,000, Alice can “exercise” her option. She buys the car from Bob for $50,000, and she can immediately sell it for $80,000. Her profit would be $28,000 ($80,000 sale price - $50,000 purchase price - $2,000 premium). If the movie is a flop and the car's value drops to $40,000, Alice lets the option expire. She doesn't have to buy the car. Her only loss is the $2,000 premium she paid. Bob keeps the $2,000 and his car.

To understand calls, you need to speak the language. Here are the key players and pieces of the puzzle:

• Buyer (or Holder): The person who pays the premium for the right to buy the underlying asset. In our story, this was Alice.
• Seller (or Writer): The person who receives the premium and has the obligation to sell the underlying asset if the buyer decides to exercise the option. This was Bob.
• Premium: This is the cost of the call option contract itself. It's the non-refundable price you pay for the right. The premium is influenced by the stock's price, the strike price, the time until expiration, and the stock's volatility.

A call option's life is finite, and time is its greatest enemy.

• Expiration Date: This is the final day the option contract is valid. After this date, it becomes worthless. Options can have expirations ranging from a few days to over two years (the latter are known as LEAPS).
• Time Decay (or Theta): This is the silent killer of an option's value. All else being equal, the premium of a call option will decrease each day that passes. This erosion of value accelerates as the expiration date gets closer. For an option buyer, the clock is always ticking against you.

This “moneyness” describes where the stock price is relative to your option's strike price. Let's say you own a call option for XYZ Corp. with a $100 strike price.

• In-the-Money (ITM): The stock's current market price is above your $100 strike price (e.g., $105). Your option has intrinsic value because you could exercise it to buy the stock for less than it's currently trading for.
• At-the-Money (ATM): The stock's price is at or very near your $100 strike price.
• Out-of-the-Money (OTM): The stock's price is below your $100 strike price (e.g., $95). The option has no intrinsic value, as it would be cheaper to buy the stock on the open market.

This is the most common use. An investor who is very bullish on a stock's short-term prospects can buy calls to get more bang for their buck. For a relatively small premium, they can control a large number of shares (one option contract typically represents 100 shares). If they are right and the stock price soars past the strike price, the percentage gains on their premium can be astronomical. However, if they are wrong and the stock price stays flat or falls, they can easily lose 100% of their investment—the premium paid. It's a high-leverage, high-risk bet on price movement.

A more sophisticated (and less common for individuals) use is for hedging. For instance, an investor who has engaged in short selling a stock (betting its price will fall) is exposed to unlimited risk if the stock price rises instead. To cap this potential loss, they could buy a call option. If the stock price unexpectedly skyrockets, the gains on their call option would help offset the massive losses on their short position. In this context, the premium is like an insurance payment to protect against a catastrophic event.

For followers of Benjamin Graham and Warren Buffett, buying calls is generally a non-starter. The philosophy of value investing is built on a few core pillars that stand in direct opposition to the nature of call options.

• Ownership vs. Betting: Value investing is about becoming a part-owner of a wonderful business, purchased at a fair price. You are entitled to a share of its future earnings and assets. A call option is a derivative; it's a side bet on a price movement. It gives you no ownership rights, no dividends, and no say in the company.
• Long-Term vs. Short-Term: The value investor's best friend is time, allowing a great business to grow its intrinsic value. The option buyer's greatest enemy is time, as time decay constantly erodes the value of their position. The two mindsets are fundamentally incompatible.
• Intrinsic Value vs. Price Action: A value investor's work is in calculating what a business is truly worth, independent of its fickle stock price. An option speculator is concerned almost exclusively with which way the price will move in the near future.

Warren Buffett famously called derivatives “financial weapons of mass destruction.” While some sophisticated investors use options in very specific ways (like selling covered calls to generate income on stocks they already own and intend to keep), these are advanced strategies. For the ordinary investor building wealth the value-investing way, calls are a siren song that should be ignored. The path to long-term success isn't found in clever bets that might pay off in three months, but in patiently owning pieces of excellent businesses for years.