A call option gives the buyer the right, but not the obligation, to buy the underlying stock or asset at a specific price (the strike price or exercise price) within a specific period of time (expiration date). The buyer of the call option only risks the premium that he paid. If the stock finishes below the strike price, the call buyer will have only lost the original purchase price. Investors might allocate a small percentage of their portfolio to call buying while the rest earns interest in a secure instrument like a T-bill. If the call options expire, the investor has limited downside. On the other hand, a speculator might buy many call options to leverage a stock position. They are more likely to trade in and out of the position since they have a shorter time horizon. This strategy has big risks and rewards.
If an investor purchases a $50 call and the stock is at $55, they might choose to exercise the option and buy the stock at $50. They can then sell the stock in the open market at $55. This means that the option has an intrinsic value equal to the stock price less the strike price – five dollars. They might choose to sell the option in the open market and it will be worth at least $5.
Naked call writing is the most speculative option strategy. Consequently, the SEC has established tough suitability requirements. Brokerage firms must confirm that investors have adequate experience and are highly capitalized before they can approve them for this level of option trading. Stocks can explode higher on a takeover and the risk is unlimited. Traders who sold naked calls on Google after its IPO at $100 were carried out in body bags when the stock hit $500 a year later.
Most traders start trading options using a covered call strategy. They buy the stock and sell call options to generate income and provide downside protection.