If you've been exploring the world of investing beyond stocks and ETFs, you've probably come across the term "call option." It sounds complicated, but at its core, a call option is a straightforward concept: it's a contract that gives you the right to buy shares at a specific price by a specific date. In this article, you'll learn what call options are, how they work, why investors buy and sell them, the different types, and the risks involved.
What is a call option?
A call option is a contract that gives you the right — but not the obligation — to buy a specific number of shares at a set price (the strike price) before a set date (the expiration date). You're not buying the shares themselves; you're buying the opportunity to purchase them later at a set price.
If the stock price rises above your strike price before expiration, you can exercise the option and buy the shares below the current market value. If it doesn't, you can let the option expire — the most you'll lose is what you paid to purchase the option upfront (the premium) and any fees or commissions.
Key call option terms to know
Strike price
The price at which you can buy the underlying stock if you exercise the option. When you purchase a call option, the strike price is locked in for the life of the contract.
Premium
The upfront cost of buying an option. The premium is quoted per share and typically covers 100 shares. For example, a $5 premium means you'd pay $500 total ($5 x 100 shares) — this is the maximum amount you can lose as a buyer (not including any fees or commissions).
Expiration date
The deadline by which you must decide whether to exercise your option. Once this date passes, the contract becomes worthless. Most stock and ETF options in Canada are American-style, meaning you can exercise at any time before expiration.
Call options in the money, at the money, and out of the money
These terms describe the relationship between the stock price and the strike price:
In the money (ITM) — the stock price is above the strike price, so exercising would be profitable
At the money (ATM) — the stock price is roughly equal to the strike price
Out of the money (OTM) — the stock price is below the strike price, so exercising wouldn't make sense
Why would someone buy a call option?
You'd buy a call option because you believe the stock price will rise above the strike price before expiration. If it does, you can purchase shares below the current market value — and that's a pretty attractive deal.
Call options aren't limited to stocks, either. You can buy them on exchange-traded funds (ETFs), bonds, indices, and some commodities. In every case, buying a call option is a bullish strategy — a bet that the underlying price will rise before the contract expires.
How call options work
Here's what a call option could look like in practice:
You're eyeing a stock, $PEAR, that's currently trading at $150 per share. You believe that it might rise to $175 soon so you decide to buy a call option with a strike price of $155 and an expiry of 30 days. The premium for the call option is $5 per share ($500 total for 100 shares).
You were right - the stock rises to $175 before the contract expires. You can exercise your right to purchase 100 shares at $155 each ($15,500 total), then turn around and sell them at market price ($17,500) for a $1,500 profit. But $15,500 isn't chump change, so you can also choose to sell the option contract itself instead, letting someone else take advantage of the discounted share price.
But what if $PEAR never hit $175? Let's say it fell to $145. You could try to sell the option to a more optimistic investor, likely at a loss, or let it expire worthless. The maximum amount of money you could lose is the $500 premium you paid plus any fees or commissions.
Why would someone sell a call option?
You can also sell (or "write") a call option. When you do, you're agreeing to sell the underlying stock at the strike price if your buyer decides to exercise. You collect the premium upfront regardless of what happens next.
There are two main reasons investors sell call options:
Income generation — you earn the premium whether or not the buyer exercises the option, creating a stream of income from shares you already own
Hedging — if you think the stock price may dip, the premium helps offset some of that decline in value
The trade-off is that if the stock price rises above the strike price, and the buyer decides to exercise the option, you'll have to sell your shares at the lower strike price — missing out on those gains.
Covered call options
With covered calls, you sell (or write) call options against stock you already own. If the option is exercised, you sell your shares to cover the call. Here's what that can look like in practice.
You own a lot of a particular stock, $PEAR, in your tax-free savings account (TFSA), which you've profited from over the last couple of years. It's currently trading at $50, and you think it could rise a little more over the long term, but want to earn some additional income while you wait. You write a covered call option with a strike price of $55, expiring in 30 days, and collect a premium of $5 per share. From here, one of two things could happen:
The stock price stays below $55: The call option expires worthless because the stock price didn't hit the strike price. You keep your $500 premium and any appreciation on your shares. For example, if the stock hits $52, you'd gain $200 of appreciation (the $2 change in stock price multiplied by 100 shares).
The stock price goes above $55: Your buyer decides to exercise the option. You keep your premium and sell your shares for $55 each, missing out on any additional profit above $55. But you still made $1,000 — $500 from the appreciation (the $5 change in stock price multiplied by 100 shares) plus the $500 premium.
Naked call options
If you're selling a naked call option, you're selling an option on shares you don't own. You'll earn a premium, but if the option is exercised, you'll have to buy the shares needed to cover the call — no matter how much they cost. (And remember, there's no limit to how high a stock price can go.) This is a very risky practice with virtually unlimited loss potential and typically requires a margin account with enough of a balance to support the position.
Let's go back to $PEAR. It's trading at $50 per share. You don't own any PEAR stock, but you think the price is going to go down. You write a naked call option with a strike price of $55, expiring in 30 days, and collect a premium of $5 per share.
The stock price stays below $55: The call option expires worthless. You keep your $500 premium and don't have to buy any shares.
The stock price goes above $55: Your buyer exercises the option. You keep your premium, but now you have to buy the shares at the current price and sell them at the strike price, resulting in a loss. If the price rose to $75, you'd buy 100 shares at $75 ($7,500), sell them for $55 each ($5,500), and after deducting your $500 premium, face a $1,500 loss.
How to Buy and Sell Call Options
Like buying and selling stocks, you can access call options through a trading platform or online broker. Many account types can be enabled for options, including margin accounts, TFSAs, first home savings accounts (FHSAs), and registered retirement savings plans (RRSPs).
Opening an options trading account is sometimes more involved than opening a regular brokerage account. Because options trading is riskier than many other types of investing, firms screen applicants to protect against significant losses.
Firms often screen applicants, looking at things like:
their investing experience (with options and other financial instruments)
their financial information (including their liquid, or cash, net worth)
their investing objectives (both generally and specifically around options trading)
Once you're ready to buy or sell call options, you can review an option chain and choose the parameters of the call option, including:
strike price
expiration date
number of contracts (the quantity of call options available to buy or sell; each contract represents a standardized number of shares of the stock)
From here, you'll watch the price of the stock and decide whether or not to exercise the option to buy the shares before the expiration.
Risks of call options
Options trading can be rewarding — and risky. There's no guarantee of returns, and inexperienced traders could face significant losses without proper risk management. Here's a quick summary of the key risks:
Buying a call — the most you can lose is the premium you paid plus any fees or commissions
Selling a covered call — you may have to surrender your shares if the buyer exercises the option, causing you to miss out on further gains
Selling a naked call — you may need to buy shares at market price (which could be much higher than the strike price) to cover the contract, creating potentially unlimited losses
Getting started with call options
Call options can be a useful tool once you understand the mechanics — but they're not something to jump into without preparation. Start by getting comfortable with the basics of how stock markets work, then explore options with small positions and defined risk.
If you're interested in learning more, consider reading about put options next — they're the other half of the options equation. And once you're confident with the fundamentals, strategies like covered calls can help you put your knowledge into practice.
