When you buy a call option, you are buying the option to buy a stock at a certain price. The value of a call option is based on three factors: its strike price, its length and its volatility. By understanding how these factors combine, you can better predict whether a call option is worth buying.
To buy a call option, you need to pay a fee to a call seller. In exchange, the person selling you the call promises to sell you the stock at that price, no matter how high it is actually priced in the market. The price that you can buy the stock is called the strike price. When a new call option contract is written, the strike price is set above the stock's current market price. The stock price needs to go above the strike price for your option to be worth using.
The strike price of your call option has a big part in determining the option's value. The lower your option's strike price, the more valuable your option is. This is because it's more likely that the underlying stock will go above a low strike price than a high strike price. Since your call option only earns money if the stock price goes above the strike price, a lower strike price makes the option more valuable.
The time remaining in your option contract also affects its value. The longer your option contract has before it expires, the more is it worth. A longer time period creates a higher chance that the stock price will hit the strike price of your option. There is more time for the market to swing up or for the underlying stock to receive unexpected good news. If your option contract runs out of time before hitting its strike price, it becomes worthless.
Volatility is the amount a stock's price goes up and down. The more volatile a stock, the more valuable its call option. If a stock's price is bouncing up and down, it has a greater chance of hitting your strike price. It only needs to go above your strike price once for your call option to make money. If a stock's price has low volatility and stays around the same point, it is less likely to hit your strike price before it expires.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.