Buying Index Calls Explained

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How to Buy Call Options Explained: The Ultimate Guide

Buying a call option is probably the first type of trade that a beginner option investor will make. Usually, this is because they don’t have enough money to buy the actual shares of stock.

Unfortunately, this can be a big mistake because they don’t understand the important factors like time value and option greeks. Many new option investors can end up losing money on the calls even if the stock moves in the right direct for them.

In this article we will explain the key criteria you need to understand before buying a call option so you can avoid the common money losing mistakes.

How to buy Call Options

Investors will buy call options when they are bullish on a stock. Most active stocks have options for them. The more actively traded that a stock is, the more selection there is in different option strikes and expiration periods.

If you are brand new to options then you will need to notify your broker that you would like to get approved for trading options. There are different approval levels based on what option strategies you want to do. Buying calls is the most basic level for option account approval.

Once you have option approval then you can start looking at the various options that are available for stocks that you are looking at. You will see the calls listed by expiration period and then by the strike prices that are currently available to buy.

A call option has a strike price that allows the call option buyer to buy the stock at that specific strike price. The goal is for the stock price to rise above the option strike price. If the stock doesn’t go above that strike price then the call option will expire worthless.

Buying a call option example

Let’s say it is September and you were were interested in buying ABC stock that is currently trading at $25 a share. You are bullish on ABC stock and think it will go up by next month when they release their new product.

You look at the various options that are available for ABC stock. You don’t believe that ABC will start going up until October so you skip over September calls since they will expire. You look at November calls to give yourself some time for the ABC stock to move.

Buying November calls instead of October calls will have less time value erosion. Time value begins to rapidly erode in the final month of expiration.

Looking at the available November calls, you can either buy:

  • In-the-money November $22 call for $4.20 (Intrinsic value $3 / Extrinsic Value $1.20)
  • At-the-money November $25 call for $1.70 (Intrinsic value $0 / Extrinsic Value $1.70)
  • Out-of-money November $28 call for $0.90 (Intrinsic value $0 / Extrinsic Value $0.90)

You can see how the extrinsic vs. intrinsic value varies among the three different calls and you have to decide on how confident you are that ABC stock will appreciate by November.

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If ABC stock only goes to $29 then you will barely breakeven on the $28 calls.

Usually the safer bet is to buy calls that are farther in the money to get the similar dollar-for-dollar move as owning the actual stock.

Buying calls requires a much lower investment than buying stock.

Call Buying Risks

The above call buying example explained the basic concept of call buying but you have to understand how time value and volatility affect option prices because options are priced based on probabilities.

Time value simply means that as an option gets closer to expiration that it has less likelihood of making larger moves. This means you will see faster time value erosion on options especially options that are out-of-the money.

High volatility means that the stock price moves a lot and therefore option sellers will demand a higher price for options that they sell on a stock.

For an option buyer, if volatility drops then you could end up seeing the value of the calls you bought drop significantly even if the stock price hasn’t moved. This happens quite often after news events like earnings announcement or after a big move in the overall stock market.

Most options brokers will show you the volatility for each option expiration period so make sure you aren’t overpaying for an option. You can also lookup the historical volatility for a stock to see where it currently ranks vs. its past history.

Generally, you want to buy low volatility options and sell high volatility options.​

Call Buying Summary

In this article we covered the important concepts to understand when looking to buy call options. Here a great video giving you a visual understanding of buying calls.

Editor’s Note : Before you buy make sure you get expert advice. You can sign up for trade alerts from John Thomas , a trading veteran and a founding father of the hedge fund industry.

Call Option Definition

What Is a Call Option?

Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer profits when the underlying asset increases in price.

A call option may be contrasted with a put, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.

Key Takeaways

  • A call is an option contract giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time.
  • The specified price is known as the strike price and the specified time during which a sale is made is its expiration or time to maturity.
  • Call options may be purchased for speculation, or sold for income purposes. They may also be combined for use in spread or combination strategies.

Call Option Basics

The Basics of Call Options

For options on stocks, call options give the holder the right to buy 100 shares of a company at a specific price, known as the strike price, up until a specified date, known as the expiration date.

For example, a single call option contract may give a holder the right to buy 100 shares of Apple stock at $100 up until the expiry date in three months. There are many expiration dates and strike prices for traders to choose from. As the value of Apple stock goes up, the price of the option contract goes up, and vice versa. The call option buyer may hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock or sell the options contract at any point before the expiration date at the market price of the contract at that time.

The market price of the call option is called the premium. It is the price paid for the rights that the call option provides. If at expiry the underlying asset is below the strike price, the call buyer loses the premium paid. This is the maximum loss.

If the underlying’s price is above the strike price at expiry, the profit is the current stock price, minus the strike price and the premium. This is then multiplied by how many shares the option buyer controls.

For example, if Apple is trading at $110 at expiry, the strike price is $100, and the options cost the buyer $2, the profit is $110 – ($100 +$2) = $8. If the buyer bought one contract that equates to $800 ($8 x 100 shares), or $1,600 if they bought two contracts ($8 x 200). If at expiry Apple is below $100, then the option buyer loses $200 ($2 x 100 shares) for each contract they bought.

Important

Call options are often used for three primary purposes. These are income generation, speculation, and tax management.

Covered Calls for Income

Some investors use call options to generate income through a covered call strategy. This strategy involves owning an underlying stock while at the same time writing a call option, or giving someone else the right to buy your stock. The investor collects the option premium and hopes the option expires worthless (below strike price). This strategy generates additional income for the investor but can also limit profit potential if the underlying stock price rises sharply.

Covered calls work because if the stock rises above the strike price, the option buyer will exercise their right to buy the stock at the lower strike price. This means the option writer doesn’t profit on the stock’s movement above the strike price. The options writer’s maximum profit on the option is the premium received.

Using Options for Speculation

Options contracts give buyers the opportunity to obtain significant exposure to a stock for a relatively small price. Used in isolation, they can provide significant gains if a stock rises. But they can also result in a 100% loss of premium, if the call option expires worthless due to the underlying stock price failing to move above the strike price. The benefit of buying call options is that risk is always capped at the premium paid for the option.

Investors may also buy and sell different call options simultaneously, creating a call spread. These will cap both the potential profit and loss from the strategy, but are more cost-effective in some cases than a single call option since the premium collected from one option’s sale offsets the premium paid for the other.

Using Options for Tax Management

Investors sometimes use options to change portfolio allocations without actually buying or selling the underlying security.

For example, an investor may own 100 shares of XYZ stock and may be liable for a large unrealized capital gain. Not wanting to trigger a taxable event, shareholders may use options to reduce the exposure to the underlying security without actually selling it. While gains from call and put options are also taxable, their treatment by the IRS is more complex because of the multiple types and varieties of options. In the case above, the only cost to the shareholder for engaging in this strategy is the cost of the options contract itself.

Real World Example of a Call Option

Suppose that Microsoft shares are trading at $108 per share. You own 100 shares of the stock and want to generate an income above and beyond the stock’s dividend. You also believe that shares are unlikely to rise above $115.00 per share over the next month.

You take a look at the call options for the following month and see that there’s a 115.00 call trading at $0.37 per contract. So, you sell one call option and collect the $37 premium ($0.37 x 100 shares), representing a roughly four percent annualized income.

If the stock rises above $115.00, the option buyer will exercise the option and you will have to deliver the 100 shares of stock at $115.00 per share. You still generated a profit of $7.00 per share, but you will have missed out on any upside above $115.00. If the stock doesn’t rise above $115.00, you keep the shares and the $37 in premium income.

The Basics of Covered Calls

Professional market players write covered calls to increase investment income, but individual investors can also benefit from this conservative but effective option strategy by taking the time to learn how it works and when to use it. In this regard, let’s look at the covered call and examine ways it can lower portfolio risk and improve investment returns.

What Is a Covered Call?

You are entitled to several rights as a stock or futures contract owner, including the right to sell the security at any time for the market price. Covered call writing sells this right to someone else in exchange for cash, meaning the buyer of the option gets the right to own your security on or before the expiration date at a predetermined price called the strike price.

A call option is a contract that gives the buyer the legal right (but not the obligation) to buy 100 shares of the underlying stock or one futures contract at the strike price any time on or before expiration. If the seller of the call option also owns the underlying security, the option is considered “covered” because he or she can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing.

Covered Call

Profiting from Covered Calls

The buyer pays the seller of the call option a premium to obtain the right to buy shares or contracts at a predetermined future price. The premium is a cash fee paid on the day the option is sold and is the seller’s money to keep, regardless of whether the option is exercised or not.

When to Sell a Covered Call

When you sell a covered call, you get paid in exchange for giving up a portion of future upside. For example, let’s assume you buy XYZ stock for $50 per share, believing it will rise to $60 within one year. You’re also willing to sell at $55 within six months, giving up further upside while taking a short-term profit. In this scenario, selling a covered call on the position might be an attractive strategy.

The stock’s option chain indicates that selling a $55 six-month call option will cost the buyer a $4 per share premium. You could sell that option against your shares, which you purchased at $50 and hope to sell at $60 within a year. Writing this covered call creates an obligation to sell the shares at $55 within six months if the underlying price reaches that level. You get to keep the $4 in premium plus the $55 from the share sale, for the grand total of $59, or an 18% return over six months.

On the other hand, you’ll incur a $10 loss on the original position if the stock falls to $40. However, you get to keep the $4 premium from the sale of the call option, lowering the total loss from $10 to $6 per share.

Bullish Scenario: Shares rise to $60 and the option is exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $60 – option is exercised because it is above $55 and you receive $55 for your shares.
July 1 PROFIT: $5 capital gain + $4 premium collected from sale of the option = $9 per share or 18%
Bearish Scenario: Shares drop to $40 and the option is not exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $40 – option is not exercised and it expires worthless because stock is below strike price. (the option buyer has no incentive to pay $55/share when he or she can purchase the stock at $40)
July 1 LOSS: $10 share loss – $4 premium collected from sale of the option = $6 or -12%.

Advantages of Covered Calls

Selling covered call options can help offset downside risk or add to upside return, taking the cash premium in exchange for future upside beyond the strike price plus premium.during the contract period. In other words, if XYZ stock in the example closes above $59, the seller makes less money than if he or she simply held the stock. However, if the stock ends the six-month period below $59 per share, the seller makes more money or loses less money than if the options sale hadn’t taken place.

Risks of Covered Calls

Call sellers have to hold onto underlying shares or contracts or they’ll be holding naked calls, which have theoretically unlimited loss potential if the underlying security rises. Therefore, sellers need to buy back options positions before expiration if they want to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.

The Bottom Line

Use covered calls to decrease the cost basis or to gain income from shares or futures contracts, adding a profit generator to stock or contract ownership.

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