Options Basics: How Options Work.
Options contracts are essentially the price probabilities of future events. The more likely something is to occur, the more expensive an option would be that profits from that event. This is the key to understanding the relative value of options.
Let’s take as a generic example a call option on International Business Machines Corp. (IBM) with a strike price of $200; IBM is currently trading at $175 and expires in 3 months. Remember, the call option gives you the right , but not the obligation , to purchase shares of IBM at $200 at any point in the next 3 months. If the price of IBM rises above $200, then you “win.” It doesn’t matter that we don’t know the price of this option for the moment – what we can say for sure, though, is that the same option that expires not in 3 months but in 1 month will cost less because the chances of anything occurring within a shorter interval is smaller. Likewise, the same option that expires in a year will cost more. This is also why options experience time decay: the same option will be worth less tomorrow than today if the price of the stock doesn’t move.
Returning to our 3-month expiration, another factor that will increase the likelihood that you’ll “win” is if the price of IBM stock rises closer to $200 – the closer the price of the stock to the strike, the more likely the event will happen. Thus, as the price of the underlying asset rises, the price of the call option premium will also rise. Alternatively, as the price goes down – and the gap between the strike price and the underlying asset prices widens – the option will cost less. Along a similar line, if the price of IBM stock stays at $175, the call with a $190 strike price will be worth more than the $200 strike call – since, again, the chances of the $190 event happening is greater than $200.
There is one other factor that can increase the odds that the event we want to happen will occur – if the volatility of the underlying asset increases. Something that has greater price swings – both up and down – will increase the chances of an event happening. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.
With this in mind, let’s consider a hypothetical example. Let's say that on May 1, the stock price of Cory's Tequila Co. (CTQ) is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example. On most U. S. exchanges, a stock option contract is the option to buy or sell 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.
Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and take your profits – unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride.
By the expiration date, the price of CTQ drops down to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down by the original premium cost of $315.
To recap, here is what happened to our option investment:
So far we've talked about options as the right to buy or sell (exercise) the underlying good. This is true, but in reality, a majority of options are not actually exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE​, only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthless.
At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and extrinsic value, also known as time value. An option's premium is the combination of its intrinsic value and its time value. Intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. Refer back to the beginning of this section of the turorial: the more likely an event is to occur, the more expensive the option. This is the extrinsic, or time value. So, the price of the option in our example can be thought of as the following:
In real life options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely. If you are wondering, we just picked the numbers for this example out of the air to demonstrate how options work.
A brief word on options pricing. As we’ve seen, the relative price of an option has to do with the chances that an event will happen. But in order to put an absolute price on an option, a pricing model must be used. The most well-known model is the Black-Scholes-Merton​ model, which was derived in the 1970’s, and for which the Nobel prize in economics was awarded. Since then other models have emerged such as binomial and trinomial tree models, which are also commonly used.

Call options trading explained

A call option is a financial contract that gives the buyer the right, but not the obligation, to buy an underlying security (like a stock, futures contract, currency, etc.) at a specific price at any time until the contract expires.
Traders can buy-to-open a call option as well as sell-to-open.
As a buyer, i. e. a long call, you only have the right to buy the appropriate amount of the underlying security if the call option is in-the-money, but you never have the obligation.
Therefore, a seller of a call option contract, i. e. a “naked” or short call, always has the obligation to sell the appropriate amount of the underlying securit if the short call option is in-the-money.
How Call Options Work.
Call options for most US stocks, futures, and indices are also known as plain vanilla options and fall under two categories: American Style Options and European Style Options. Almost all stock options in the US are American Style. Some index options, like SPX and NDX, are European Style.
American style options can be exercised at anytime prior to expiration, assuming the option is in-the-money.
European style options can only be exercised at the expiration date of the option contract, assuming the option is in-the-money.
For a stock, 1 call option equates to 100 shares.
For a futures contract, 1 call option typically equates to 1 futures contract.
How Traders Use a Call Option.
Traders primarily use calls for three reasons: speculation, hedging, and reducing cost-basis.
Speculation : Buying calls in anticipation of the underlying asset increasing in value prior to expiration is known as speculation. This is a risky trade, because if the underlying asset (like a stock or futures contract) does not increase in value before expiration, the purchased call options will expire worthless. Similarly, traders can sell a call option in anticipation that the underlying asset will not appreciate prior to expiration and the call option will expire worthless. Option sellers profit on the premium collected.
Hedging : It is also common practice to buy call options as a hedge against a potential increase in the underlying asset. This is one of the most common ways short sellers hedge their positions. Essentially, shorting a stock and and buying a call is the equivalent to buying a stock and buying a put.
Reducing Cost Basis : Covered calls are by far the most common way traders use call options and reduce their overall cost basis. If a trader owns 100 shares of XYZ at $50, for example, he can sell 1 out-of-the-money call option at any strike price contract against his existing long shares. Assuming he sells a $55 call option for $0.80, he will keep the full $80 in premium unless XYZ is above $55.80 at expiration. If XYZ is above $55.80 at expiration, the trade will produce a net profit of $580. No matter what happens, the trader gets to keep the $80 in call option premium.
Basic Strategies Involving Call Options.
Because a call option can either be bought or sold to initiate a trade, there are a variety of options trading strategies traders can take advantage of with calls.
In addition to outright long calls and short calls, there are call debit spreads and call credit spreads, which are essentially hedged variations of buying and selling calls.
Related posts:
What are Put Options? A put option is a financial contract that gives the buyer the right, but not the.
A call option is considered to be in the money if its strike price is below the current price of.
What are stock options calls and puts? Stock options have two forms: calls and puts. From these two forms of.
The covered call option strategy is a mildly bullish options trading strategy that involves selling a call option on an.

We Provide Free Derivatives Trading Insight.
So You Can Trade Smarter, Not Harder.
Latest Posts.
How to Buy CME Bitcoin BTC Futures.
Bitcoin futures are the hottest commodity on the market today. So hot, in fact, that the Chicago Mercantile Exchange, also.
Interactive Brokers is Dangerous for Options & Futures Trading.
Interactive Brokers is one of the largest online discount brokers in the world. They average over 1,000,000 client trades every.
BTC Futures vs XBT Futures – What’s the Difference?
BTC futures and XBT futures both track the price of bitcoin, so what’s the difference between the two sets of.
Bloomberg Terminal Review – Is it Worth $2k a Month?
The Bloomberg Terminal is one of the most iconic financial data platforms in the world. Recognized by the unique blue.
Where to Buy Bitcoin futures – Best Broker BTC Futures.
Are you wondering where to buy bitcoin futures? Well, bitcoin futures are now available to trade on the CFE, the.
How to Short Bitcoin XBT Futures.
Bitcoin is a fascinating financial instrument, and the cryptocurrency world has forever changed with the introduction of bitcoin futures (trading.
How to Buy XBT Bitcoin Futures.
Now that bitcoin futures have finally been created by the Cboe, what is the best way to buy XBT bitcoin.
How to Trade Bitcoin Futures – And Why You Should.
The day is finally here! The Cboe Futures Exchange, a division of the Cboe Global Markets Exchange is now offering.

The Options & Futures Guide.
Learn option trading and you can profit from any market condition. Understand how to trade the options market using the wide range of option strategies.
Discover new trading opportunities and the various ways of diversifying your investment portfolio with commodity and financial futures.
To help you along in your path towards understanding the complex world of financial derivatives, we offer a comprehensive futures and options trading education resource that includes detailed tutorials, tips and advice right here at The Options Guide .
Profit graphs are visual representations of the possible outcomes of options strategies. Profit or loss are graphed on the vertical axis while the underlying stock price on expiration date is graphed on the horizontal axis.
Option Basics:
Before you begin trading options, you should know what exactly is a stock option and understand the two basic types of option contracts - puts and calls. Learn how they work and how to trade them for profits. [Read more. ]
Binary Option Basics:
Binary option trading is quickly gaining popularity since their introduction in 2008. Check out our complete guide to trading binary options. [Read more. ]
Beginner Strategy:
The covered call is a popular option trading strategy that enables a stockholder to earn additional income by selling calls against a holding of his stock. [Read more. ]
Stock Option Advice:
Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read more. ]
Stock Option Trading Basics:
For the short to medium term investor, stock option investing provide an additional suite of investment options to let him make better use of his investment capital. [Read more. ]
Advanced Concepts:
When trading options, you will come across the use of certain greek alphabets such as delta or gamma when describing risks associated with various options positions. They are known as "the greeks". [Read more. ]
Option Trading Advice:
Many options traders tend to overlook the effects of commission charges on their overall profit or loss. It's easy to forget about the lowly $15 commission fee when every profitable trade nets you $500 or more. Heck, it's only 3% right. [Read more. ]
Stock Options Advice:
Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read more. ]
Advanced Concepts:
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read more. ]
Advanced Concepts:
Another way to play the futures market is via options on futures. Using options to trade futures offer additional leverage and open up more trading opportunities for the seasoned trader. [Read more. ]
Stock Option Advice:
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read more. ]
Stock Options Tutorial:
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read more. ]
Stock Options Advice:
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read more. ]
Stock Option Tutorial:
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read more. ]
Follow Us on Facebook to Get Daily Strategies & Tips!
Options Basics.
Futures Basics.
Bullish Strategies.
Bearish Strategies.
Neutral Strategies.
Synthetic Positions.
Options Arbitrage.
Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account. You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon.
The financial products offered by the company carry a high level of risk and can result in the loss of all your funds. You should never invest money that you cannot afford to lose.