By Stock Options Channel Staff
The option to buy a specified quantity of a given stock at a given strike price, before a certain date.
Call options are a type of contract, giving the holder of the contract the right to buy the specified stock, at the specified price (called the "strike price"), with the contract expiring on the specified expiration date. These contracts are standardized and anyone with an options-enabled account at a brokerage can buy or sell them.
When might someone buy a call option? Suppose for example, a stock you like was trading at $9/share and you were very bullish on that stock, thinking it will soon go to $11 in a matter of months. If you had $900 to invest (plus some additional money for the broker's commission), you could buy 100 shares of the stock at $9. If it goes to $11 and you sell, you will have made a $200 profit. What if you used your $900 towards buying call options instead? A call option at the $10 strike price a few months out might trade in the neighborhood of 20 cents — a price that represents the "premium" per share over the strike price. The typical standard option contract represents 100 shares, meaning in this example each contract would cost you $20. So for $900, you could buy 45 contracts. Let's see what happens next in various scenarios.
In one possible scenario, you were wrong about the stock soon going to $11, and it continues to hover around the $9 mark all the way through to the expiration of your call options. In this scenario, you have lost all $900 — versus if you had purchased stock with that money at $9 you would have lost nothing.
In another possible scenario, the stock trades higher but not all the way to $11, instead it trades right up to your break-even point at $10.20. In this scenario, you would be able to sell your contracts before expiration and recoup your $900 (we are ignoring commissions, but in reality you would lose money in the amount of your broker commissions).
And in the scenario where you were right and the stock rose to $11, you would up 60 cents per contract. They had cost you 20 cents, so by selling the options at 80 cents you have quadrupled your money — you made $2,700 profit, or $2,500 more than you would have made just by buying the stock. You have in essence leveraged your upside to being right about your bullish stance on the stock, but you have greatly increased your risk of completely losing your investment. Even if you were "right" about the stock reaching $11 but wrong in your timing, you could still lose your full $900 if the stock had still not broken above $10 by the time the option expired, even if $11 was reached the following day.
Another important consideration to think about in the call option scenario is how you are likely to react to movements up and down, for example if your position was to fall in value by $200 and then rebound, eventually reaching a profitable position. If at first you were underwater but then your profit in the call options scenario started to reach $200 for example, would you have cashed out? Buying call options carries significant downside risk as we highlighted, but often times we have seen option buyers cash in a small gain once they have one — in essence capturing a small amount of profit that arguably would not have justified taking the initial downside risk, versus just buying the stock itself in the first place.
There are a lot more variables to buying call options that can be considered, for example instead of buying the $10 strike in the above example, which was "out of the money" (meaning, the stock would have to rise to reach that strike price), what if you had bought the $5 strike? With different strike prices, it is possible to shift the risk/reward spectrum.
While buying calls can be a way to gain leverage and amplify risk/reward, another strategy to consider is being on the other side of the trade and selling calls for income.
Now Learn About: Put Options »
Since 2003, our company has operated the stock picking discussion community ValueForumTM, where members gather each year for an event we call InvestFestTM. Both online and at these events, stock options are consistently a topic of interest. The two most consistently discussed strategies are: (1) Selling covered calls for extra income, and (2) Selling puts for extra income.
The Stock Options Channel website, and our proprietary YieldBoost formula, was designed with these two strategies in mind. Each week we put out a free newsletter sharing the results of our YieldBoost rankings, and throughout each day we share even more detailed reports to subscribers to our premium service.
On the CALLS side of the options chain, the YieldBoost formula looks for the highest premiums a call seller can receive (expressed in terms of the extra yield against the current share price — the boost — delivered by the option premium), with strikes that are out-of-the-money with low odds of the stock being called away.
On the PUTS side of the options chain, the YieldBoost formula considers that the option seller makes a commitment to put up a certain amount of cash to buy the stock at a given strike, and looks for the highest premiums a put seller can receive (expressed in terms of the extra yield against the cash commitment — the boost — delivered by the option premium), with strikes that are out-of-the-money with low odds of the stock being put to the option seller.
The results of these rankings are meant to express the top most ''interesting'' options identified by the formula, which are meant as a research tool for users to generate ideas that merit further research.
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