What is a Call Option?

Call options give the buyer a right to buy some specific asset. They have a specific expiration date, strike price, and underlying security. The value of the call is derived from the underlying security's price. Buying a call option is a bullish strategy. Selling a call option is bearish.

Bullish Call Option Strategy

Google (GOOG) currently trades over $600 per share. A person who is bullish on the stock may believe that fair value is closer to $700. They could buy a deep in-the-money call option to reduce the cost of investing in the stock. The $500 January 2012 call option has an ask price of $128.30. If the investor buys this contract, they will essentially be paying $628.30 for the stock ($500 strike price plus the cost of the call option), but because they are buying a call option, they are leveraging their investment. The extra $28.30 spent is a premium that has no intrinsic value, just time value.

At the options expiration date, if the stock trades over $500, then the call gives the holder the ability to buy the stock at $500. If the stock is trading at $700, the profit on the position would be $72, on a $128 investment. This represents a 56.25% return.

If the stock trades at less than $628, the position will result in a loss. With the price under $500, the position would result in a complete loss of investment.

Bearish Call Option Strategy

One particular bearish call option strategy is the covered call position.  A long investor in the stock sells calls against their shares.  If the price of the stock rises above the strike price, they will be forced to sell their shares.

For example, let's say an investor owns 100 shares of GOOG.  Their investment is worth $60,000 based on the current price of $600.  They may believe that the price will not rise above $625 by the April expiration date.  So, they could sell 1 call option at a strike price of $625 with an April 2011 expiration.  The bid price on this call is $11.30. The sale of this call option would create a cash inflow of $1,130 to the portfolio.  Over a period of 43 days, this strategy would yield cash income of 1.8%, or a 15.98% annualized return.

If the shares are called, the profit would be 6.05%, or 51.35%.