At its simplest, a call option is an agreement between a stock buyer and seller to purchase specific shares at a given price within a specified time frame. On the face of it, this arrangement is advantageous to the buyer who retains a right to purchase without the commitment to do so. The seller, on the other hand, is obliged to convey the stock if the buyer exercises the option.
This relationship contrasts with that of a put option, where the right to exercise lands on the seller. When the purchaser holds the right, that person must determine whether going through with the deal makes sense.
Read More: How Does a Put Option Work?
Know the Strike Price of the Option
Ultimately, the value of the call option itself is derived from the stock value. Yet for the purpose of profit/loss calculation, the most immediately important figure is the strike price, which is the price the underlying stock must reach in order to possess intrinsic value and the price at which the buyer can purchase before the contract expires.
This, it must be stressed, does not guarantee profit. It is merely the first variable in calculating P&L. Strike price is indicated on the trade ticket or broker's statement.
Read More: Why Is a Call Option Called a Call?
Follow the Value of the Stock or Asset
The Wall Street Journal, Yahoo! Finance and Bloomberg are but a few resources through which you can follow the price of the stock or commodity. The difference between the current price and the strike price will tell you whether you would be taking a gain or loss: if the strike price is higher than the current price, you would take a loss of the amount of the difference. For call options to possess value at the point of their expiration, the stock price must exceed the strike price.
Read More: How to Track the Stock Market
Do Not Forget the Premium
Should the stock price sit above the strike price, there might still be little cause to celebrate. When the premium, the cost of the call option itself, is factored in, any profit in the stock could be canceled out. So, if the current asset price is $47 and the strike price is set at $43, the option looks profitable indeed. However, if the premium is $6, then you lose.
According to NASDAQ, option premiums are formulated using the stock price/strike price difference, the contract time period and the volatility of the stock, or how much the price oscillates. While premiums are usually modest, they can impact value when using call options.
Other Variables Affecting the Transaction
Since time and volatility play into premium amounts, these are often key indicators of call option success. An investor should look at how the underlying stock has moved. While not using exact science, some savvy investors have made a reliable art out of stock prediction.
Beyond direction, option buyers should also consider the size of the movement: by how much have those upticks or downturns traveled? Over how much time did such movement occur?
What to Keep in Mind
The profit or loss you take on a call option is equivalent to the price of the stock when the contract expires minus the break-even point. The break-even point includes both the strike price and the cost of the call option, or the premium. The premium price can give hints to how the underlying stock or asset has been performing over a given stretch of time.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.