In this article we will explain call options and how you can use them in your investing plan.
A Call option is a contract where the option buyer has the right to buy a specific stock (or any underlying security) at a specified price within a certain period time. Each call option controls 100 shares.
Buying a call is a bullish trade as it benefits when the underlying stock goes up and selling a call is a bearish trade as the call option seller loses money when the underlying stock does up.
The key components when evaluating a call option are:
Strike price - which is the price at which you can buy stock if you exercised the call.
Expiration Date - the date on which the option expires and becomes worthless.
Premium - This is the price you pay when you buy an option. You need to multiply the quoted price by 100 to understand the investment amount that is needed. For example, a call option price of $1.40 would cost you $1.40 x100 = $140 per option
What is the Call Option Value Derived From ?
The call option price is comprised of intrinsic value (how far the option is in-the-money) and extrinsic value (time value).
A Call option’s price is a combination of whether its strike price is above or below the current stock price as well as external (extrinsic) factors like the volatility of the underlying security, the time until expiration, and how active the option is traded.
It i is very important to understand how option value is derived because option call value can erode faster if:
- Its strike price is above the current stock price (out of the money).
- If the stock becomes less volatile.
- If time gets closer to expiration.
The more conservative call option buyer will prefer to buy in the money so that is has less time decay but this requires a larger investment to buy the call option.
A riskier investor will buy out of the money calls which are 100% valued on extrinsic value and much more susceptible to time decay as it approaches expiration.
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Call Option Delta
A key factor to consider when buying call options is the option delta, which a statistical metric for measuring how the option will move in relation to price movement of the underlying stock.
This simply means that the closer delta is to 100 the more the option will move dollar for dollar with the underlying stock.
For example, a call option with a 65 delta means it will appreciate $0.65 in value for every $1.00 move of the underlying stock. The farther in-the-money the call you buy, the higher the delta.
Stock call option example
Now that we have covered the basics of an option call, let us get into an example so you can have a better understanding of how option call works.
The current price of XYZ stock is $50 per share and Investor “A” thinks the stock will increase dramatically. Investor “A” buys 1 call contract (controls 100 shares) with a strike price of 50 for $4 or $400 total.
If XYZ stock stays flat or doesn’t goes up then the call contract expires worthless and Investor “A” loses $400.
If XYZ stock goes up to $60 then Investor “A” can exercise the call and buy the stock for $5000 ($50 strike price x100) and sell it for $6000. This results in a profit of $1000 - $400 call option premium = $600 profit.
Realize in this example that a $600 profit on a $400 investment has generated 150% return. That is the power of options.
Call Option Buyer Profit & Loss Graph
Call Option Seller Profit & Loss Graph
Image Source: Wikipedia
Covered call strategy is probably one of the most well-known options strategies using call options. It involves owning a stock and selling calls in that same stock with a strike price that is above the current stock price.
This allows the stock owner to generate income like a dividend on the stock that they own.
This strategy is widely used by professional money managers and mutual funds that don’t want to buy and sell their stock holdings for tax reasons and can collect more return on their funds by selling calls against their stocks.
In this article we covered more details about calls and provided an example of call option strategies that you could implement in your portfolio.
If you are having a hard time understanding what is call option then this video below will help provide a more visual explanation of how they work.
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