You can profit from a stock’s price increase by purchasing a call option. This strategy is favored by both novice and experienced options investors due to its simplicity.
Here’s how it works: You buy a call option on a stock or other equity if you expect its market price to exceed the strike price plus the premium by the expiration date. Alternatively, you might buy a call option if you anticipate that the option’s premium will rise sufficiently to offset the effects of time decay. In both cases, the goal is to benefit from the anticipated price movement of the underlying asset.
If your expectation proves accurate, buying a call option can lead to a positive return. Conversely, if the stock price does not rise as anticipated, the most you can lose is the premium you paid for the option. This loss is typically much smaller compared to the potential loss if you had purchased the stock outright and its value declined.
What is a call option?
When discussing options trading, people usually refer to two types: calls and puts. A **call option** is one that gains value as the price of a stock rises. It is among the most popular options and grants the owner the right to buy a specific stock at a predetermined price by a certain date. Call options are particularly attractive because they can appreciate significantly with even a modest increase in the stock’s price, making them a favored choice for traders aiming for substantial profits.
When you buy a call option, you acquire the right to purchase the underlying asset at the strike price on or before the expiration date. Call options can also serve as a hedge for your positions if the price of the underlying security or commodity declines. The price of the call option is influenced by the likelihood that it will be profitable to exercise it before it expires.
Investors use call options for several reasons:
- Leverage: Call options allow investors to profit from an increase in the underlying stock price while paying only a fraction of the cost required to buy the actual shares.
- Hedging: Investment banks and other businesses use call options as part of their hedging strategies to manage risk and protect against price fluctuations.
How does the buying call options work?
A valuable strategy to boost your portfolio’s profitability involves buying call options, selling them, or exercising them for a gain. When you purchase a call option, you obtain the right to buy shares at a predetermined price (the strike price) on or before the option’s expiration date, in exchange for paying the option premium. This strategy allows you to benefit from potential increases in the underlying stock’s price while managing your initial investment costs.
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- Exercise the Option: The buyer can acquire the shares from the call seller by paying the strike price.
- Sell the Option: The buyer can sell the option before it expires to realize a profit.
If the stock price is below the strike price at expiration, the call option is “out of the money” and expires worthless. In this case, the premium paid for the option is lost, and any premium received for the option remains with the call seller. When the stock price is equal to the strike price at expiration, the option is “at the money.”
The advantage of buying a call option is that it allows you to benefit from increases in the stock price beyond the strike price, for a relatively low upfront cost. This strategy is typically employed with the expectation that the stock’s price will rise before the option expires.
How does time affect call options?
The time remaining until an option’s expiration affects its premium. Generally, the more time there is until expiration, the higher the option’s premium, as the holder has a longer period for the stock to move above or below the strike price.
Buying call options can be advantageous over different time frames:
- Short Term: Investors can profit by selling the option for more than they initially paid, especially if the stock price rises before expiration.
- Medium Term: Over several months, call options can help manage risk in an uncertain market. Investors can also use this period to lock in a purchase price or buy LEAPS (Long-Term Equity Anticipation Securities) to secure a long-term position.
- Long Term: LEAPS allow investors to buy call options with a long expiration period, providing the opportunity to accumulate capital and buy the underlying shares at a favorable strike price before expiration.
What does exercising your call option mean?
In options trading, “to exercise” means to use your right to buy or sell the underlying security as specified in the options contract. Most call options are sold before expiration to realize a profit from changes in the premium. However, if you purchased a call with the intention of owning the underlying asset, you can exercise the option at any time before expiration, as long as it aligns with your brokerage’s exercise policies.
If you don’t sell the option or exercise it before expiration, you will forfeit the entire premium paid. If your call option is out-of-the-money at expiration, it is unlikely you will exercise it. For an at-the-money option, transaction fees might outweigh the benefits of exercising. On the other hand, if your option is in-the-money, it is important to act before expiration to avoid losing the potential gains.
CHOOSING A SECURITY
In general, buying call options reflects a bullish outlook. You should consider purchasing calls on a stock or stock index that you believe will increase in price. This could be a stock you expect to rise in the short term, enabling you to benefit from a rise in the option’s premium. Alternatively, you might choose a stock with long-term growth potential that you wish to own. By purchasing calls, you can secure a favorable purchase price, with the only cost being the premium paid for the option.
Call options vs buying stock on margin
For certain investors, buying call options can be a more attractive alternative to buying stock on margin. Calls provide similar leverage to margin trading but with reduced risk. When buying on margin, you need to maintain a reserve of cash in your margin account to cover potential losses. If the stock price declines, you may need to add cash, sell part of your position, or face forced liquidation by your brokerage.
In contrast, purchasing call options offers the advantage of a lower initial investment. If the stock price falls, the primary risk is the loss of the premium paid for the option, which is typically much smaller than the margin requirement. This makes buying calls a potentially less risky way to gain exposure to stock price movements.
Is buying a call worth it?
Buying call options can be suitable for various investment goals. For instance, if you want to lock in a future purchase price for shares without committing the full investment amount upfront, buying call options allows you to do so. Alternatively, you might use a buy low/sell high strategy by purchasing a call option you anticipate will increase in value, with the intention of selling it for a profit. It’s crucial to choose a call option that responds as expected, as not all call options will move significantly even if the underlying stock rises.
Additionally, experienced investors might buy call options as a hedge against short sales. Short sellers profit from a decline in a stock’s price but face potential losses if the stock price rises instead. By purchasing call options, short sellers can protect themselves against unforeseen price increases and limit their risk exposure.
The Truth About Buying Call Options by Inna Rosputnia
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