The Truth About Buying Call Options

What is a call option?

When someone talks about options or options trading, they often mean trading two different options: calls and puts. A sort of option that gains value as a stock rises is called a call option. They are the most well-known options and allow the owner to fix a price to purchase a particular stock by a specific date. Call options are desirable because they can increase value rapidly on a slight stock price increase. As a result, traders seeking a significant profit tend to select them.

If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. Call option buyers use them as a hedge against their position if the price of the security or commodity falls. The likelihood or improbability that the option buyer will be able to exercise the option before expiration profitably determines the option’s price. Investors use call options for the following reasons:

• With call options, investors can profit from an increase in the underlying stock price while only paying a portion of the cost of purchasing actual stock shares.
• Call options are used as hedging strategies by investment banks and other businesses.

How does the buying call options work?

A great strategy to enhance the profitability of your portfolio is to buy calls, sell them, or exercise them for a profit. Purchasing a call gives you the right to buy shares at a set price (the strike price) on or before the option’s expiration date in exchange for the option premium.

When the stock price is higher than the strike price at expiration, call options are “in the money.” There are two alternatives available to the buyer. First, the buyer can acquire the stocks from the call seller by exercising the option and paying the strike price. Second, the buyer could benefit by selling the option before it expires.

The call is “out of the money” and expires worthless if the stock price is lower than the strike price at expiration. Any premium received for the option remains with the call seller. The call option is “at the money” when the stock trades at the strike price.

The benefit of buying a call option is that it increases stock price gains. You can benefit from a stock’s gains over the strike price until the option expires for a relatively low up-front payment. Therefore, you typically expect the stock to increase before expiration if you buy a call.

How does time affect call options?

Time will also have an impact on the option’s premium. Since the holder has more time for the stock to rise above or below the strike price, the longer the contract is before expiration, the more expensive it will be. Buying calls can provide an advantage over several different periods:

• Short term. Investors can profit if they sell an option for more than they paid for it, for example, if there is an increase in the stock’s price before the expiration.
• Medium-term. Over several months, investors can use call options to minimize the risk of owning stock in an uncertain market. Investors who want to lock in a purchase price for a year or longer can buy LEAPS or periodically purchase new options.
• Long term. LEAPS allow investors to purchase calls at a strike price they’re comfortable with and accumulate the capital to buy those shares in the intervening time until expiration.

What does exercising your call option mean?

In options trading, “to exercise” means putting into effect the right to buy or sell the underlying security specified in the options contract. Most call contracts are sold before expiration, allowing their holders to realize a profit if there are gains in the premium. If you’ve purchased a call with the intent of owning the underlying instrument, however, you can exercise your right at any time before expiration, subject to the exercise cut-off policies of your brokerage firm.

But, if you don’t resell and don’t exercise before expiration, you’ll lose all of the premium you paid. If your call is out-of-the-money at expiration, you most likely won’t exercise. If your option is at-the-money, transaction fees may make it not worth exercising. But if your option is in-the-money, you should be careful not to let expiration pass without acting.

Call options vs buying stock on margin

For certain investors, buying calls is an attractive alternative to buying stock on margin. Calls offer the same leverage you can get from buying on margin, but you take on less potential risk. If you buy stock on margin, you must maintain a certain reserve of cash in your margin account to cover the possible loss in value of those stocks.

If the stock price does fall, you must add cash to meet the margin requirement, liquidate a portion of your position, or face having your brokerage firm liquidate your assets. If you purchase calls, you have the same benefit of low initial investment as the margin trader. Still, if the value of the stock drops, the main risk you face is loss of the premium, an amount that’s usually much smaller than the initial margin requirement.

Is buying a call worth it?

Call buying may be appropriate for meeting many different objectives. For example, if you’d like to establish a price at which you’ll buy shares at some point in the future, you may buy call options on the stock without having to commit the full investment capital now. Or, you might use a buy low/sell high strategy, buying a call that you expect to rise and hoping to sell it after it increases in value. In that case, it’s key to pick a call that will react as you expect since not all calls move significantly, even when the underlying stock rises.

Some experienced investors may purchase calls to hedge against short sales of stock they’ve made. Investors who sell short hope to profit from a decrease in the stock’s price. If the shares increase in value instead, they can face heavy losses. Buying calls allows short sellers to protect themselves against the unexpected increase and limit their potential risk.

The Truth About Buying Call Options by Inna Rosputnia

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