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
Image Source: Wikipedia Call Buyer Profit/Loss Graph
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.
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.