Friday, 20 September 2019

Call Options: The Basics of Buying and Selling

Call Options: The Basics of Buying and Selling
23 Jan
4:09
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Along with put options, call options are one of the two major kinds of options, and they’re the kind most investors think of when they hear the word “option.” Call options make money when a stock rises, and they’re the kind of option employees try to wrangle when they join a company, hoping the options soar in value as the company’s stock rises.

Here’s what you need to know about call options, including how to buy and sell them. (If you need a quick refresher on how options work, see this beginner’s guide to options.)

What is a call option?

A call option is a contract that allows the owner to buy a stock at a specific price — called the strike price — by a certain future time. The buyer of the option pays the seller a fee — called a premium — for this right. If the stock price is higher than the strike price when the option expires, the call option is “in the money” and is worth money. If not, the call expires worthless.

Each option contract represents 100 shares of the underlying stock. For example, if you own five contracts, your position tracks the movement of 500 shares of the stock.

Options are a directional bet on a stock’s movement and, importantly, when it will happen. A call buyer expects the stock to rise above the strike price by expiration, ideally much higher than the strike. Conversely, a call seller expects the stock to remain flat or decline over the same time. Of course, only one of these bets on the market can be correct, so the winner’s profit comes at the expense of the loser. It’s like a side bet on how the stock will perform.

Publicly traded options are standardized, meaning the details are already specified for each possible contract. You can’t just go out and buy whatever option terms you want.

If you want to buy an option, you’ll need to evaluate it based on the following characteristics:

  • Expiration: when the option expires
  • Strike price: the price at which the option becomes valuable (or worthless)
  • Type: a call option or a put option
  • Underlying stock: the stock you’re buying the option on

Once you’ve got these details sorted, you can buy or sell an option.

How to buy a call option

If you’re buying a call, you’ll want to consider whether the stock can finish above the strike price plus your purchase price before the option expires. If so, you’ll earn a profit on the option. Even if you don’t profit, as long as the stock remains above the strike at expiration, the call will retain some value. However, if the stock is below the strike at expiration, the call expires worthless.

Investors like call options because they can magnify gains massively, and you can earn gains on much more stock than you could own outright. Here’s an example of how it works, compared to directly owning the stock.

In this example, the stock is trading at $50, a call with a strike price of $55 is available for $5, and you have $1,000 to invest. Here are the profits and losses at expiration at various prices.

Stock price Profit/loss owning stock Profit/loss owning calls
$30 -$400 -$1,000
$35 -$300 -$1,000
$40 -$200 -$1,000
$45 -$100 -$1,000
$50 $0 -$1,000
$55 $100 -$1,000
$57.50 $150 -$500
$60 $200 $0
$65 $300 $1,000
$70 $400 $2,000

With your money, you’ll be able to buy 20 shares of stock, and every $5 rise in the stock translates to a $100 gain. If the stock falls $5, you’ll be down $100. But the payoff profile is much different for the call options, with much higher upside and downside.

With $1,000, you can purchase two contracts (2 * $5 * 100) with a strike price of $55. For every price below $55, the contracts will expire worthless and you’ll lose the whole investment. The options won’t break even until the stock is at $60 at expiration. But above that level, the calls will pay off handsomely, increasing $1,000 in value for every $5 rise in the stock price.

So that’s the attraction of buying calls — the possibility of a much larger gain than with the same investment in stock.

How to sell a call option

Selling (or writing) a call option is a much different proposition and makes money if the stock stays flat or declines in value at expiration. As an options seller, you want the option to expire worthless so you get to keep the entire premium.

Selling calls can be a dangerous trade because the potential upside is uncapped. The stock could simply keep rising, and the options seller is on the hook for any losses, potentially losing way more than the premium received from selling the call.

Using the same example as before, here are the profits and losses at expiration at various prices for the call seller. Note that the numbers are exactly the opposite of the call buyer’s.

Stock price Profit/loss selling calls
$30 $1,000
$35 $1,000
$40 $1,000
$45 $1,000
$50 $1,000
$55 $1,000
$57.50 $500
$60 $0
$65 -$1,000
$70 -$2,000

Selling $1,000 worth of call options means you can sell two contracts. For every price below the strike price of $55, the call seller will retain the entire premium of $1,000. Even if the stock goes up a bit to $57.50, the call seller will make some money. But at a stock price of $60 and above, the call seller begins to lose money quickly, $1,000 for every $5 rise in the stock price.

Selling calls can be a dangerous strategy, but there’s one variation — named the covered call — that is lower-risk and potentially even safe enough for retirees. (Here are the details.)

What to watch out for

The biggest drawback of trading call options is the potential total loss if the stock finishes at the wrong place at the wrong time. It can become a complete loss of capital, and there’s no reset button.

And just as important as correctly predicting the stock’s move, you’ll have to predict the time frame too. If the stock moves higher the day after expiration, it won’t matter at all. The options will have already expired worthless. It’s like having the right lottery numbers for the wrong drawing.

Call sellers need to pay particular attention because they can lose more money than they put into a trade. Since a stock could continue rising, the call seller may lose many times more money than they receive in the premium. That could prove catastrophic.

Finally, if there’s one saving grace when buying call options, it’s that even if a stock moves against you, the option often retains some value as long as there’s a lot of time left until it expires. So that allows you to close the position and not take a complete loss.

Bottom line

Buying and selling calls can be a very lucrative way to make money in the stock market, but it’s not without important risks that should be considered before you commit any capital. Yet even more so than trading stocks, it takes an iron stomach and nerves of steel to watch options prices fluctuate, sometimes violently. Hold on to your emotions.

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James F. Royal, Ph.D.

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Source: https://www.magnifymoney.com/blog/investing/call-option-buying-selling/

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