Key Points
- Call options are a versatile tool for traders and investors.
- Fundamental to market mechanics, every investor must know how they work.
- Options are part of the secondary investment market and are a derivative trading instrument.
Call options are a versatile tool for traders and investors that can supercharge portfolio returns. They can be used to speculate the movement of securities and, more importantly, hedge against market downturns. The risk with call options is that they can be a two-edged sword; the leverage they provide will boost your portfolio when the market is moving in your favor but can cost an entire investment when the market moves against you.
Because they are fundamental to market mechanics, every investor must know how they work whether or not they choose to harness the power of call options. The purpose of this article is to give an in-depth explanation of what a call option is and how investors can profit from it. After reading this article, you will know what you need to take the next step with options.
Understanding Call Options
Options are part of the secondary investment market and are a derivative trading instrument. Options are based on an underlying asset and can exist on virtually any security. Options allow investors to capitalize on their holdings and speculators to profit from the movement of asset prices. Options are traded on major exchanges and even OTC via standard brokerage accounts.
An equity option is a contract to buy or sell a stock. Regarding call options, the contract is to buy a stock at a certain price; the call contract can be bought or sold by investors.
The option contract price, the price you would pay for the stock if you decide to buy it, is the strike price. The strike price is an important term to remember because it determines profits.
Call options that expire above the strike price expire with value and potential profits for buyers. Call options that expire below the strike price expire worthless and make a profit for sellers. The best part is that an options trader can profit with a call option and never buy the underlying stock.
- Put Options: Put options are the exact opposite of a Call Option. A put option allows the holder to sell a stock at the strike price before expiration. In this example, the owner of a put option would profit if the stock price fell. The holder of a Call option profits when the underlying stock price rises.
Each call option contract is for control of 100 shares. If you own the contract, you can buy 100 shares of the stock at the strike price at any time up to and until expiration. This is known as exercising the option.
Expiration is another important concept because options are limited by time. The shortest-duration options expire in only 1 day, while the longest-ended options expire in 2 to 3 years or longer. Options with more than 1 year until expiry are also called LEAPS or long-term equity anticipation securities.
- The Options Chain: The Options Chain is a table listing all the available options for a given asset. The chain may include only a few strikes and expiration dates for lightly traded assets, but commonly held stocks will have numerous choices. Actively traded stocks like Apple may have strike prices every $2.50 increment from $0 to twice the stock’s price, expiring from 1 day to many years.
Each call option contract has 2 sides: the seller and the buyer. A seller must own 100 shares of the underlying stock to sell 1 call option contract. The option seller lists their desired price, which may be a limit, stop, or market order; that is the Ask price. The option buyer offers the Bid price, which may also be a limit, stop, or market order. When the bid/ask match up, a contract is made.
- At-the-money-options: At-the-money call options have a strike price at or near the underlying stock's price. If the stock trades near $30, the $30 strike price would be considered at-the-money. At-the-money is important because that is the pivot point where profits are made. An option that expires at the money expires worthless.
- In-the-money options: In-the-money call options have a strike price below the underlying stock's price. In this event, the option has both time value and intrinsic value. The time value is the cost of holding the option until expiration, and the intrinsic value is the difference between the strike price and stock price. If the stock price is $50 and the option price is $45, then the option has $5 of intrinsic value and whatever time value is left.
- Out-of-the-money options: Out-of-the-money call options have a strike price above the underlying stock price. In this case, the option only has time value and no intrinsic value. Out-of-the-money options are among the riskiest because they suffer fast time decay or loss of value as time expires.
Option Premium: It’s the Price You Pay for Options
The option premium is the price that you pay for your call options. It includes the time value, the intrinsic value, and any additional valuation the market may put into the price. A stock expected to move strongly following an earnings report may have options trading at a higher premium than ordinary, which is a risk for options traders. Options with inflated premiums may have already priced in the expected move and will provide no profits for new buyers.
Implied Volatility: Implied volatility measures expected market movement for stocks and is typically available on all trading platforms. A stock with a high IV or an elevated IV compared to normal has options that tend to trade at a more expensive price point and may not be the best buyer choice. Conversely, options with high IV come with an above-average premium and may be of interest to options sellers. Many websites feature Options Profits Calculators to help predict potential gains.
Mechanics of Call Options
The mechanics of call options differ for buyers and sellers. It is important to understand the difference.
The Basics of Selling a Call Option
For example, Bob owns 100 shares of XYX, which he bought for $30, which has increased by 50% to $45. Bob is concerned about a market downturn and wants to lock in that profit but keep his stock, so he chooses to sell an option. Bob now has 3 choices: does he sell an in-the-money option, an at-the-money option, or an out-of-the-money option?
- Options traders with sufficient experience and capital reserves may sell uncovered, cash-secured options.
Because Bob wants to keep his stock, he chooses to sell an out-of-the-money option. He enters his order to sell the option to buy his stock for $1.50 per share or $150 per contract with 1 month until expiration. His strike is $48. One month later, shares of XYZ are still trading at $45, and the option expires worthless. Bob pockets the $150 or 3.3% of his position when trading at $45, and he is free to do the same thing again the next month.
Options Assignment: However, if XYX shares were to increase above $48, Bob would be assigned and have to sell his shares. He would be obligated to sell at $48, a $3 premium to the price when he sold the options. In this case, he profits an additional $3 per share + $1.50 in option premium for $4.50. Add that to the 50% gain he already had, which brings the total to $19.50 in profits or 65% compared to only 60% without selling the option. If Bob sold calls more than 1 once, his returns are greater.
The Basics of Buying a Call Option
Bob has discovered a company he believes is trading at a value and will outperform already robust expectations when it reports earnings. Bob knows that out-of-the-money options are the riskiest because of time decay and delta, the amount of movement in the underlying stock to get a $1.00 movement in the option premium, so he targets at-the-money and slightly in-the-money options.
Bob also knows that options with the shortest time until expiry have the fastest time decay or theta; he’s targeting 3 months until expiration. That gives him enough time to wait for the earnings release without risking too much time decay.
Bob’s target stock, ABCD, is trading near $12, so he starts with the $12 calls. Those come with an elevated implied volume, so he moves down to the $11 strike, providing a better risk-reward profile. Bob decided to purchase 1 contract of ABCD at $11 with 3 months until expiration at $2.35 per share. 5 weeks later, the company reports earnings and shares spike.
Shares of stock ABCD advanced 40% to $16.80, providing $5.80 of intrinsic value for Bob plus the remaining 7 weeks of time value. That added up to $7.10 per share or $710 compared to the $235 purchase price for a profit of $4.75 per share or $475. That’s a gain of 200% or 5X the underlying stock gain.
Bob now has 3 choices. The first choice is to risk his profit and hold the option until expiration. He may keep the $4.80 intrinsic gain in this scenario, but the time value will erode. The 2nd case is to “exercise” the option.
Exercising a stock option: Exercising a stock option means taking possession of the stock or buying it from the option seller. Exercising options is easy and is usually done with a button click and directly from the brokerage account. The cost of the stock is equal to the strike price and, regarding in-the-money options, would grant the holder an immediate profit. To capture the profit, Bob will have to take another step and sell the stock.
Bob’s 3rd choice is to sell the option. In this scenario, Bob relinquishes his right to buy the stock but profits the full amount, intrinsic and time value. The new option owner may or may not be able to profit from their position.
Option Pricing and Valuation
Options have existed for decades but were not commonly traded until the mid-1970s. A mathematical model we know as the Black-Scholes model was introduced for effectively pricing the options market, opening the door to retail options trading. The model is based on 6 factors: volatility, type, strike price, time, stock price, and risk-free rate. This model has been improved but is still the basis for option price modeling today. Other factors affecting an options price are implied volatility, the underlying business relative to its peers, and fear.
Strategies and Practical Applications
There are numerous practical applications of call option trading for traders and investors. These strategies can often be used in conjunction with each other or put options to create complex positions that profit regardless of the movement or direction in the underlying position.
Speculation: Speculation is the most visible use of options trading. Options provide a less-expensive means to gain exposure to the underlying asset and can return far greater amounts than stocks alone. Speculators may target directional moves, reversals, or range-bound assets and profit with call options.
Leverage: Call options can provide tremendous leverage to investors. An options contract with 60 to 90 days until expiration may cost 80% to 90% less than shares of the underlying asset. This provides short-term traders a means to enhance their leverage without using margin. The caveat is that leverage can result in sharp losses, and Pattern Day Traders may have no choice but to open a margin account.
Hedging: Investors fearing a market downturn can hedge against the possibility by selling call options. If the market should fall, the option premium will help offset the difference. Hedging strategies can be taken to the next level and used to produce income-generating investments.
Covered calls: Covered calls are a hedging strategy that aims to buy a stock and sell a call against it to earn a premium. The most successful trades result in the call option exercised and the trade producing maximum profit for the trader. Maximum profit is the difference in the purchase and sale price of the stock plus the option premium.
Bull-call spreads: Bull-call spreads are exactly like a covered call with 1 difference; instead of buying the stock and selling the option, the trader buys a call option and then sells another call option at a higher strike price against it. This produces the same effect with the added leverage of lower expense.
Risks and Considerations
There is considerable risk when trading call options up to and including total loss of position. Options are time-sensitive and lose value each day until expiration, even if the stock price remains steady or increases. If the market fails to produce the desired movement before expiration, an option could expire with less value than at the time of purchase or out-of-the-money.
Options that expire out-of-the-money expire worthless and provide no exit strategy for investors. Investors who speculate on market movement with shares of the underlying stock will always have the stock, provided the company remains viable.
Call options trading should only be done after careful consideration because of the risk. Prudent call options trading involves significant risk management and experience with market movement. Options traders should never invest more than a tiny fraction of their accounts and always use money management strategies such as stop-loss orders.
Before trading, all options traders must read and sign an ODD or options disclosure statement. The ODD is commonly known as the Characteristics and Risks of Standardized Options.
Conclusion
Call options are a fundamental part of the market and a useful tool for traders. They provide a means for investors and traders to rent a stock for a specific period and profit from its movement. Call options can provide leverage, enhance returns, and hedge against market downturns, but they come with risks. The 2 most significant are that investors could lose 100% of their options trade, and the 2nd is that they may be forced to sell stock they would rather keep.
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