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If you’ve been trading stocks and are at the point where you feel like you have a hang of the market, you might be able to forecast stock price movement reasonably. However, It might be time to expand your trading knowledge into more advanced strategies like options trading, particularly calls and puts, which can help you amplify profits and limit losses. Learning about a call option is an excellent first place to start.
Trading options are complex because they are specific about everything from time to price plus there are many different option strategies you can deploy. They intensify your gains as well as losses and are therefore considered risky. But they are also used as tools to manage risk. As Warren Buffett says, “Risk comes from not knowing what you’re doing.”
This article will cover everything a first-time trader needs to know about the call option to help you make informed trade and manage your risk-reward.
Beginners Guide To Call Options And How To Trade Them (With Example)
What Is a Call Option?
- A call option buyer has the right, not an obligation, to buy the underlying shares at a pre-determined price on or before the expiration date by exercising the option.
- A call option seller has an obligation to sell the underlying shares at the pre-determined price if the buyer exercises the option.
A call option contract has three key components:
- Strike price: The price at which the buyer can exercise the call option to purchase the underlying stock.
- Premium: The price buyer pays to buy the call option from the seller.
- Expiration date: The date when the option contract ends.
An equity option contract represents 100 shares of the underlying stock. A call option for Apple stock would state the following details; call option for Apple stock with a strike price of $140 expiring on December 30, 2022, at a premium of $0.50 per share. The option contract will cost you $50 ($0.50 x 100 shares). For $50, you get the right to buy 100 shares of Apple for $140 each by December 30, 2022. Call options are used when an option trader is bullish that the stock will go up, whereas a put option or naked put is used if the option trader is bearish.
Types of Call Options
A call option is exercised when the buyer uses their right to buy the stock at the strike price. When you can exercise your option depends on the option type. You can exercise an American-style option any time before the expiration. Most equity options are American style.
But you can exercise a European-style option only at expiration. Most broad-based equity indices have European-style options. While you can’t exercise them before the expiration date, you can sell them on the options exchange for a premium.
How To Make Money From Call Options?
A buyer buys a call option if they are bullish on the stock and expects the stock price to rise above the strike price at expiration. If this happens, a call option is “in the money (ITM),” which means the buyer is motivated to exercise the option.
How strong the motivation is depends on the stock’s trading price. The higher the stock price above the strike price, the deeper in the money the call option. In our first example, the call option will achieve breakeven at $140.5 ($140 strike price + $0.50 option premium). We will take three scenarios and identify the option buyer’s action.
- Apple stock trades at $150 at expiration; your call option is worth $950 ($150 – $140.5 breakeven for 100 shares). Your option is deep in the money, and the buyer exercises the call. The seller bears the loss of $950.
- Apple stock trades at $140 at expiration; your call option is worth -$50 ($140 – $140.5 breakeven for 100 shares). Your option is at the money, and the buyer may or may not exercise the call.
- Apple stock trades at $138 at expiration; your call option is worth -$250 ($138 – $140.5 breakeven for 100 shares). Your option is out-of-the-money (OTM), and the buyer will let the call expire. The call seller gets the $50 premium.
|Stock Price||Strike Price||Breakeven||Option Profit||Option status||Buyer’s action|
|$140||$140||$140.5||-$50||At-the money||May or may not Exercise|
|$138||$140||$140.5||-$250||Out of the money||May Not Exercise|
A call option with a lower strike price is more likely exercised.
How Are Call Options Priced?
Depending on the current stock price, the option seller and buyer can plan their next move and mitigate their risk. You can trade options on the options exchange. In the first scenario, the seller can buy another call option with similar components and reduce its loss to the option premium.
The option premium is the compensation the buyer pays the seller for taking the risk. Think of it like insurance. Your insurance premium amount increases when the risk of claim rises. Similarly, the call option premium increases when the seller has a higher risk of facing a loss.
The Black-Scholes model is the most popular method of option pricing. But we won’t bombard you with complex math formulas. The option pricing has two major components:
Time value is the probability the buyer will exercise the option. This value depends on the time; the longer the period, the lower the time value.
Intrinsic value is the profitability of the option (Trading price – Strike price). This value depends on the market’s expectation of the stock price volatility; the higher the implied volatility higher the intrinsic value.
In-the-money options include both time and intrinsic value and command a higher premium. Out-of-the-money options only include time value and hence command a lower premium.
Why Should You Buy A Call Option?
Many people buy call options for various reasons. Some traders buy call options to speculate and earn an arbitrage profit. They expect stock prices to rise in the near term because of seasonal buying or the passage of a bill. Some buy call options to hedge the risk from higher prices. An airline buys a call option to hedge against rising oil prices.
Buying stocks has benefits, as you are eligible to receive dividends and have voting rights. Moreover, you can buy and hold stocks till perpetuity. But if you are looking for short-term gains, a call option can give you exposure to stock price for just a fraction of the amount. Buying a call option magnifies your profits and limits your downside risk to the amount of option premium. Here’s how.
For instance, Mary buys ten shares of XYZ at $20/share for $200. Jane purchases a call option for the same stock at a premium of $200 and gets the right to buy 100 shares for $20 each. At the option expiration date, the stock price is $30. Mary’s profit is $100 (50%), and Jane’s profit is $800 (400%).
Why Should You Sell a Call Option?
When you sell a call option, you take a short call position, and its payoff is the opposite of a long call. A trader writes a call option to pocket the premium hoping the call expires. A short call limits your income and magnifies losses in a sudden price jump. Many hedge funds lost millions in the short-selling episode of meme stocks in 2021.
Many sellers can reduce the risk by writing covered calls. In the covered call strategy, a seller writes a call option for the shares they already own and earn an option premium. The seller keeps writing call options as and when the previous one expires to earn regular income from options while also earning dividends (if any) from the stock. If there is a sudden jump in price, the seller sells shares to the call option buyer and settles the contract.
We have only covered the basics of call options. There are many options trading strategies like a long straddle, short straddle, and short selling for various scenarios. You can be in the options market to earn income, hedge risk, or make speculative trades. It has something for everyone.
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