A call is a type of option. It is generally understood to be the
right, but not the obligation, to buy an asset at a certain price
(the strike) at or before a certain time.
Wow, that's a mouthful. So, what does it mean? It means that we
can buy an asset - for instance, a stock, or a bond, for cheap if it
goes up. If the stock goes down, I simply don't buy. This has three
- If the stock goes up, I make money. Hence, it's the same as virtually
owning some stock.
- If the stock goes down, the (potential) profit for the option will go
down. The good news here is that I can never be obliged to buy the
stock, so, at worst, my option is worthless. Because options only cost a
fraction of really buying the stock, my loss may be limited.
- A call always has a positive value. Because the potential gains become
smaller as it gets closer to expiry, a call continuously loses a bit of
There are a few other, subtle points worth mentioning about buying
calls. Firstly, if you own shares, you might get a dividend. Owners
of calls don't get these dividends. This may be partially priced into the
call. Sometimes, it's a good idea to exercise the call - buy the shares -
before the dividend, so you get the shares and the dividend. Whether or not
this is a good idea is a question fit for an expert.
The flip side of this is that investing in a call only requires a
fraction of the cash of buying the stock. This means the rest can be
put in a bank and get you interest. This is also priced into a call.
market makers are smart like that.
There are two important variables in trading calls: The strike
and the duration. A higher strike means I need to pay more to eventually
buy the share. To compensate, the call is cheaper, meaning you need less
money or can buy more. High strikes are "bets" that the stock will go up a
lot (a takeover comes to mind), while lower strikes are more like "discount
investments" with limited risk.
If the duration of the option is longer, it has more time to rise. This
has a particularly strong effect on calls with high strikes: it may be
unlikely that a share rallies 10% a month, but 10% a year is certainly
possible. These options are also more expensive.
Selling a call can be done if you don't think a stock will go up.
This is tricky; you might lose a LOT if it does go up - in fact, your
potential loss is completely unlimited. However, what is often done is
buying shares and then selling the call, in particular one that
has a strike above the current price of the share. In this construction,
you get dividend and money for selling the call. Furthermore, if you go
up, you first make on the stock, and then sell it for the agreed price,
so you make money. If the stock goes down, you do lose, but the money
received for the call makes up for this. This so-called covered call -
strategy is a pretty good one for private investors.
In conclusion, a call is an option that gives the right to buy
shares at a certain price before a certain time. By buying a call, it is
possible to profit from an increase in the share price without buying
the share. If done properly, this makes it possible to invest with less,
or rather a different, risk.