September 30, 2017

Call Options: What You Need to Know

Read more about Options Trading

There's more to buying and selling stocks than meets the eye. Enter options contracts. Now you have a chance to really increase your profits. At the very least, they help you minimize losses.

Intrigued? Read on.

Buying call options can be a great strategy for new investors. Experienced investors often take it a step further and also sell (or "write") options.

We're providing you with in-depth information on these practices. When you're done, you'll understand call options and how they work.

What Is a Call Option?

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When you buy a call option, you are paying for the choice to buy a stock at a specified price within a certain time frame. It's a contract - you're agreeing to do something or, if you let the time lapse, you'll be walking away from your initial investment.

Conversely, when you sell a call option, you must sell the stock at the specified price when the option is exercised. The specified price is the strike price. We'll go into details on how you determine the right strike price later.

One contract is worth 100 shares of the stock.

How Do You Buy a Call Option?

Notice, we said you have the "choice" to buy a stock. You are never obligated. You only want to exercise this right when you are "in the money." In other words, it's only a smart thing to do if you're getting a better deal on the stock than someone who would buy shares outright on that day. In order for this to happen, the strike price must be less than the market price (what the stock is currently trading for).

Let's look at an example:

ABC stock has a current market price of $35. You can buy a call option contract with a strike price of $45. The premium on the contract is $3. It expires in 6 months. This means that within the next 6 months, if the stock price rises above $45, you'll be in the money. Because each contract equals 100 shares, you'd pay a $300 premium for this right.

Let's say in 5 months the stock price is $55.

You could exercise your right to buy the stock for $45. It would cost you $4,500. You would make $5,500 in the current market, selling it right away. It looks like you'd make $1,000 in profit, but remember, you paid the premium. In reality, you'd make $700, which is the $1,000 profit minus the $300 premium.

Now let's pretend the stock didn't rise. Instead, it fell to $30. You still hold the option to buy the stock at $45. But why would you? Instead, you'd let the contract expire. You'd be out $300. But if you had bought the stock outright, you'd lose more.

It would have cost you $3,500 for the initial stock. If the current price is $30, your shares would be worth $3,000. You'd be out $500.

What Are the Benefits of Buying a Call?

You'll realize two main benefits from the call option: unlimited profit and minimal risk. Given how scary investing can be, these are good things!

The strike price on the call limits the amount you can pay for the stock. It doesn't limit how high the market price can soar. The profits are limitless, as we showed you above.

The risks you incur are known from the start. It simply equals the amount of the premium. Remember, you multiply the cost of the contract by 100. This gives you the total premium for the 100 shares. You only risk a loss when the market price doesn't increase as you thought it would before expiration.

How Can You Sell Call Options?

An investor selling a call option is known as the writer. The writer is on the opposite side of the equation. He wants the stock price to fall. This way, the contract expires "out of the money." The seller walks away with the premium in his pocket.

Sellers can sell calls two ways: covered or uncovered (also known as "naked").

When an investor writes a covered call, it means he owns at least 100 shares of the stock. When the buyer exercises his right to buy the stock, the seller has possession of it.

An uncovered, or naked, call means the writer doesn't have possession of the 100 shares of the stock. If the buyer exercises his right to buy the stocks, the writer must buy the stocks. The writer could incur an even greater loss. He must first buy the stocks at the current market price. He then sells them to the buyer (holder) at the strike price.

The seller's losses are offset by the premium collected for the options contract.

First, let's look at an example of a covered call.

John buys 100 shares of ABC stock at $30 per share. This costs him $3,000. He then immediately writes a call option with a strike price of $40. It has a 3-month expiration and a premium of $3. Right away, John makes $300 from the buyer (holder) of the options contract.

Before the contract expires, the market price of ABC stock rises to $44. The buyer exercises his right to buy the stock for $40. The buyer pays John $4,000. John still makes a profit of $1,000, since he only paid $3,000 for the stock initially. John also made the $300 premium. In the end, John walks away with $1,300. If John didn't write the call, he could have made $1,400.

Now, let's look at an uncovered call.

John writes the same options contract for ABC stock. It has a strike price of $40 and an expiration of 3 months. The premium is still $3. The buyer pays John $300 for the options contract. Before expiration, the market price hits $45. The buyer executes the contract.

John doesn't have possession of the stock. This means he must buy the stock at the current market price of $45. John pays $4,500 for the stock. He then sells it for $40 per share. He collects $4,000. On paper, it looks like John lost $500. But he collected the premium of $300. John actually made $200 on the deal.

Of course, the hope is that you'd make more of a profit than John. We used these figures for simplicity's sake.

What Are the Benefits of Selling Calls?

Selling calls isn't for novice investors. If you have experience, though, it can be lucrative. If you're pretty good at predicting the way the market will go, you can make a decent profit.

Right away, you decrease the amount paid for the stock ownership as you collect the premium for the contract. The rest depends on how the market reacts:

  • If the stock price never rises above the set strike price, you walk away with the premium and the contract expires.
  • If the stock price rises above the strike price, you'll sell the stock. You make the difference between what you paid and sold the stock for, plus the premium you received.

If you decide you don't want to risk the option contract any longer, you can buy it back. You won't walk away with a profit. But you do eliminate your risk.

What Is the Risk of Selling Calls?

Of course, there's a risk in selling calls, just like any other investment. However, the risk is the same you'd experience if you bought the stock outright. If the market tanks and the stock price falls, you lose money. If you can ride it out, you might still come out ahead. If you are forced to sell, you'll take a loss.

Writing a call doesn't make your loss any worse. In fact, it limits your loss by offsetting it with the premium paid to you.

Don't Forget Commissions

None of these examples included commissions. Generally, the amount you have to pay a broker to help you execute transactions with options contracts is minimal. But commissions are part of the deal. If you are a very active trader, be sure to choose a low-commission broker. If you are a new trader, focus on a broker that will provide you with the most support.

The Bottom Line

Buying and selling calls can help you hedge against your losses. With a little experience, writing calls can be a way to make money right away via the premiums.

Many investors write calls to minimize their losses. It helps force them to sell when the stock hits their targeted price. Either way, you can make decent profits. Remember, diversifying your portfolio is the best way to maximize your profits. Mixing in a few options contracts with all your other investments can help give you the diversification and protection you need.

More from CreditDonkey:


How to Trade Options


Options Trading Mistakes

How to Invest in Stocks

How to Invest in Stocks

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