Call options are a great way to make the most of your capital and reduce your risks in terms of hedging. However, if used incorrectly, it can be a fast way to waste your money on premiums in hope of making huge returns. It is possible to make large leveraged returns with low risk using call options, but it requires skill and knowledge to use them correctly.
A call option gives you the right to buy stock at a fixed price in a certain period of time.
It’s named a “call” because it gives you the right to call the stock from someone else before the contract is no longer valid or expired. These contracts have many possible uses. At the most basic level, they can be purchased for yourself and sold, or written, to someone else.
These contracts are typically written for 100 shares at a time. The price you agree to pay for the stock is called the strike price, and the cost of the option contract itself is based on this price. When buying options, the cost of the contract is typically a small fraction of share price.
Buying options is a way to stretch your dollar and get leverage while also reducing the costs and risk of simply buying the stock outright. This makes it a very attractive choice, but it also can encourage unnecessary costs if not used carefully.
An In The Money or ITM call option is a contract that is purchased at a strike price below the current price. This contract has intrinsic value because it gives you the ability to buy stock cheaper than it is currently listed at.
This may be the most expensive and least exciting of call options, but it’s also the wisest and most lucrative choice. All you need to profit with ITM calls is for the stock to rise enough to cover the initial cost or premium of the option contract.
This is much more likely if the strike price is already below the current price of the stock.
An Out of The Money or OTM call option is what it sounds like. It is a contract that gives you the right to buy 100 shares at a strike price above the current price. This contract does not have intrinsic value and the stock price must rise substantially in order to make a profit.
The allure of OTM calls is strong. These contracts are usually dirt cheap and therefore provide a massive upside if the stock rises enough before the contract expires, which is typically a period of 30 days.
However, these contracts are also likely to expire worthless. Unless you have a clear edge and are virtually certain that the stock will rise above the strike price, OTM calls are a very quick way to waste your money and make zero profit. Don’t fall for the allure, these are to be used carefully.
The easiest way to use a call option is to simply buy or sell a contract at a fixed strike price for 100 shares. We’ll cover a bit more on how to read an option price chart, but first let’s take a look at some of the basic strategies for using call options.
This is the simplest method, all it involves is purchasing one or more call option contracts at a fixed price. It can be an In The Money (ITM) call or an Out of The Money (OTM) call, and the expiration is typically in 30 day increments.
However, some options expire weekly or can be purchased late for below 30 days at cheaper prices. These options are often sold at a discount, because they are much less likely to profit. The pricing of an option is based on complex statistical modeling.
This is another common method, and it involves selling, or writing, a call option while owning the underlying stock. So, you are paid a premium instantly for selling the option contract, and you must sell your underlying stock to the buyer if they choose to exercise the contract.
This is a good way to generate extra income and lock in your profits at a certain price. If the stock price reaches above the strike price of the option, then you will have to sell them your stock. However, you can make a profit selling the stock along with the premium you received.
If the stock does not reach a favorable price for the option buyer, then you just keep your premium and your stock. The tradeoff is that your stock owning profits are limited to the strike price of the option, and you still assume the normal risks of owning stocks.
This is a common yet slightly more advanced call option strategy, it is just a combination of a married put and a covered call. A put option is just like a call option, but it gives you the right to sell stock at a certain price instead of buying stock at a certain price.
If you already own the stock, you buy a put option. If the contract moves below the strike price, you can simply exercise the put option and sell it at a fixed price. This is called a married put, and it limits your losses and protects your stock investment.
Just like before, selling the covered call will provide a premium, and this will reduce the cost of buying the married put. The call will be at a higher strike price, and if the strike price is reached, then you sell your stock to the buyer and take your profit.
The bull call spread is a great way to protect, or hedge, your stock investment with a married put at a discounted premium. The tradeoff is that it limits your maximum profit to the strike price of your covered call.
You can see how the simple rules of options can be mixed and combined into creative and complex strategies. An example of two similar strategies are the straddle and the strangle.
The straddle involves buying one call and one put at the same strike price. If the price goes up, you will make money on the call. If the price goes down, you will make money on the put. The key is that the price must move enough in either direction to cover the costs of the premiums.
The strangle is similar. It involves buying one call above the current price and one put below the current price. So it works the same as the straddle, but the two contracts are spread out further from the underlying stock price. This means the price must move further to make a profit in either direction, but the premiums are less expensive as they are further out.
Normal stock trading, just buying and selling shares, is limited to directional trading. This means that you either make money from the price going up or going down. It is based purely on two dimensions of direction and time.
Options enable you to invest in three dimensions. These dimensions are direction, time, and volatility. Strategies like straddles and strangles enable you to make money just on volatility by combining option contracts, and even complex strategies like these can be further combined into more advanced strategies. There is a lot of room for creativity in option investing.
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Getting started is as simple as opening an account with a retail broker and buying or selling options through their interface. However, you must first understand how to read an option chart.
Here is an example chart, many of them ordered into separate tables or into a single table with calls and puts on opposite sides with strike prices in the center. For this example, say a stock price is currently $50.
The strike price column is the price the stock will be bought or sold at, the bid is the price to sell the contract, and the ask is the price to purchase the contract. So, buying a call option for 100 shares at a strike price of $40 would cost $255 or $2.55 per share ask price.
You can see how useful this is for leverage, as buying 100 shares outright would cost you $4,000. You still need $4,000 to buy the shares if you exercise the contract, but you could also let the contract expire and pay nothing more than the $255 upfront premium.
The same goes for selling option contracts. You can sell a call for 100 shares at the $40 dollar strike price for $245 premium. You collect the cash from the premium upfront, and nothing happens if the contract expires worthless and is never exercised.
However, if it is exercised, then you need to provide the shares at that price. If you already have the shares, then you are selling or writing a covered call. If you don’t have the shares, then you are writing a naked call and need cash to buy stock if the buyer chooses to exercise.
Call options can be a very useful tool if used correctly. However, there is still much more you can learn about them before using them in your investments.