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The world of options can seem a foreign place when people first encounter it. It’s rarely, if ever, mentioned in mainstream media. So compared to something like stocks which is always in the daily news, options can seem like a whole different world.
As with any type of trading, it pays to become familiar with the important concepts and procedures before diving in and executing trades. This article will help you on your journey by teaching you one of the most fundamental elements of option trading, called the call option.
Why Use Options?
Many people begin their trading and investing career with stocks. After all, it’s the most commonly spoken about asset class in mainstream media. If you’ve spent some time doing it, you may be asking why bother with options at all?
The reason why it’s worthwhile to consider using options, is that even though it’s an advanced tool, it offers traders and investors a number of significant benefits.
Most notably, options can be used to make big directional bets not only long (price appreciation), but also short (price depreciation), whilst protecting your downside.
Not only that, options can also be used to reduce the risk in your overall portfolio via hedging strategies, which is simply the act of pairing certain types of trades together so that if a directional bet is wrong, you won’t suffer large losses.
What Are Call Options?
Simply put, a call option is a contract between a buyer and seller. The contract will be for the right to purchase a certain stock at a certain price, up until a certain date (called the expiration date).
What this means is that up until the contract expires, the buyer of a call has the right to purchase the stocks at the agreed price.
Completing this act is called exercising the option. It’s important to note, that a call option provides the buyer with the right to purchase and not an obligation.
So if a buyer decides not to exercise the option they can let it expire worthless.
On the other hand, the seller of a call option has an obligation and not a right to deliver the stock if the buyer exercises the option. This means they have to provide the stock and can’t choose to just let it expire when a buyer exercises the option.
For example, let’s say you were to buy 1 MSFT 150 call option.
Most options are worth 100 underlying shares, so 1 MSFT 150 call option will give you the right to buy 100 MSFT shares at $150 each (called the strike price) up until the expiration date.
Suppose since you purchased the MSFT call option, the price of the stock has moved to $200 a share.
If you exercised your option at this point, it would mean you would be able to buy stocks worth $200 a share at only $150 a share, netting you $50 per share in profit instantly, for a total gain of $5,000.
It sounds like a great deal for the buyer of the call, but what is the incentive for the seller to write a call option?
Well they receive what’s called a premium, which simply means that the buyer of the call will need to pay the seller a certain price per share for the privilege.
This premium will be based on how likely, or unlikely, a trade will be profitable.
How To Use Call Options In Your Portfolio
The main benefit of using call options is that it provides investors and traders with the same upside potential that owning a stock does, whilst also providing a much more limited risk to the downside.
When you purchase a stock, theoretically the price can go up forever. This is why it’s referred to as unlimited upside potential.
However if prices go down, they can do so all the way down to zero, resulting in a total loss of your investment.
Call options can also lose all their value, however as the buyer, you get to decide what strike price you’re willing to purchase the option at.
That means you have much more control over how much of your money is at risk. Coupled with the pricing structure of options, this means that you’ll also generally pay far less for a call option than you would for the equivalent shares of stock.
As a result of this benefit and the nature of options, there are two primary ways traders use call options.
The first, is for making a directional bet on the price of a stock going up. Call option buyers will make profits from price rises in the underlying stock whilst paying only a small fraction of what it would have cost them to buy the actual stock shares.
Since call options are leveraged, the profit potential is high while losses are limited.
The second primary use for call options is for hedging.
Hedging is a technique that involves pairing certain types of trades together as a way of providing insurance for the portfolio.
Typically this involves entering one trade long and entering another trade short.
This way, if a directional bet goes wrong, the trader’s portfolio is protected from taking large losses.
A simple example might be buying a call option to hedge against an existing short position in your stock portfolio.
If the short position starts to lose money, it would be offset by the profits gained from the call option.
Conclusion
Call options are contracts between a buyer and seller, that provide the buyer with the right to purchase a set number of shares at a set price, before the contract expires.
Call options provide a means for investors to be exposed to the potentially unlimited upside of stocks, while minimising their downside risk.
In addition to making directional bets, call options can also be used to hedge a position.
Given that options are leveraged instruments, ensure you become familiar with how they work before you start trading and use appropriate risk management strategies.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
