The emerald-cut rock you slipped on your partner’s finger while down on bended knee was a symbol of your intent to marry. But in some instances — for one reason or another — that diamond might not turn into an “I do.”
You can think of a call option as the engagement ring of the investment world. Slip a call option into your portfolio and you have the option, but not the obligation, to buy shares of a stock. In the end, you may or may not follow through with the actual purchase.
Before you can determine if a call option is a match made in portfolio heaven, you need to know the basics.
Alexa, define call option.
A call option is a contract between a buyer and a seller. This contract is an agreement that gives the buyer the right to buy shares of “something,” at a pre-determined price for a limited time period. The “something” is generically known as an underlying security. Options can be traded on several types of underlying securities. Some of the most common ones are stocks, indexes, or exchange traded funds (ETFs).
Pro tip: An easy way to remember the meaning of a call option is that when you own one, you have the right to call the asset away from the investor.
Today, we will focus on the most popular type: stock options. Most stock option contracts are a right to buy 100 shares of the underlying security. So the “something” represented in our contract will be 100 shares of a specific stock, like AT&T, Apple, or Walmart.
We should emphasize that the buyer paid to have this right, which means it is not a requirement. Once the contract between the buyer and seller is final, the seller is required to sell the stock to the buyer at the price determined in the contract, if the buyer decides to buy the 100 shares of stock. This is referred to as “exercising” the buyer’s right.
This right to buy is like a limited time offer. The shares of the underlying asset are available at a specific, pre-determined price — the strike price or exercise price — during a specific timeframe (aka, the expiration date) from a seller. Exercise your right to buy, and the seller is obligated to sell you the underlying security. Once the predetermined window of time ends, you are no longer able to buy the underlying shares for the strike price.
As an options investor, you have (ahem) a lot of options, including the ability to choose between numerous strike prices and expiration dates.
But you’ll also have to pay a premium. That’s the cost of purchasing a call option.
Let’s look at an example.
Since a call option can be a bit tricky to wrap your mind around, an example makes it more relatable. Say you purchase a call option contract for 100 shares of an energy stock and pay $2.15 for the option. This contract gives you the right to buy these shares for $50 each at any point during the next three months. During this time, the price of this stock goes up and up. Near the end of your option contract, you purchase the underlying security for the strike price of $50 per share — a cost that’s cheaper than the $55 per share the stock is currently trading at.
Pro tip: Find yourself in this situation, and it’s appropriately said that your option is “in-the-money.”
To determine your profit, subtract the strike price from the current price, to determine your in-the-money amount and then add the premium paid to the difference. Lastly, you would multiply that total by 100 (since the contract is for 100 shares) to come up with the total dollar profit. If the energy stock is trading at $55, the strike price is $50, and the premium is $2.15, your profit is $2.85 per share. Your call option contact was for 100 shares, so your total profit is $2.85 multiplied by 100, or $285, less commissions. Commissions are an important factor to figure into all options trades.
You may be asking, what if the underlying stock price is less than the strike price at the end of the contract? Good question.
If that’s the case, your option is out-of-the-money with no time left, which means there is no value to owning it. Let’s use the previous call option contract example. The underlying shares of energy stock have a strike price of $50 per share. After three months — the expiration date — the price of the stock is now $47.75 per share. Since the current price is below the strike price of $50, you obviously decided not to buy the underlying shares and you’ve already paid the premium up front. Bottom line is you lost the cost of the option or $2.15. Since the contract represented 100 shares the total loss was $215 plus commission (100 x $2.15 = $215) this is often referred to as maximum loss.
As we’ve mentioned before, options trading requires a time commitment to learn the basics. It does offer investors flexibility and opportunities that other investments don’t, including the ability to speculate or act as a hedge against other investments. It can even offer a level of risk reduction, but it’s not without risk itself.
That’s why, as a self-directed or DIY trader, it’s extremely important that you take the time to understand options thoroughly before diving in. Whether this is your first go-around with options, or you’re a seasoned pro, our Options Playbook will boost your expertise.
Now to talk strategy
As you’ve probably noticed, options trading has its own terminology. It can be intimidating, but once you navigate past the jargon, you can move on to determining how to use call options as part of your overall investment strategy.
Pro tip: An individual call option is rarely used as a standalone strategy itself. Instead, it’s typically combined with stock positions and/or other call options and put options (contracts where you have the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price per share before its expiration date) of the same stock.
Numerous option strategies exist, including more common ones like covered calls, naked calls, and call spreads.
A covered call occurs when you own shares of a specific stock while simultaneously also acting as a seller of call options for the same stock. In other words, you’re selling someone else the right to purchase a stock you already own, at a specific price, within a predetermined time frame. In the investing world, this position is referred to as being long in the account.
Because you’re selling the call option, you’ll profit from the premium. And since you also own the stock, you’ll also profit from its growth — even if its per share price rises higher than the strike price and the option holder exercises their call option.
If the stock’s share price goes down, the call option won’t be exercised and the value of your holdings will decrease. But those losses can be partially offset by the premium, which you’ll pocket regardless of a security’s performance.
In contrast, a naked (or uncovered) call is when you act as a seller of call options without owning shares of the underlying stock. This position is referred to as being short in the account.
Pro tip: A naked call carries more risk, since a stock’s price could, in theory, rise endlessly above the strike price. In this situation, you don’t own any shares to offset the growth. Only the premium can reduce your losses.
For example, let’s say you write a call option with a strike price of $440 for a retail stock currently at $375 per share. By the expiration date, the stock has risen to $600 per share, meaning you’re out $160 per share (current price minus strike price). That loss will only be offset by the premium.
And your loss could be even higher. What’s keeping the stock from rising even higher before the expiration date? That’s why there’s no cap on losses from a naked call.
Call spreads are another options trading strategy you might want to consider. This approach takes advantage of different strike prices and/or expiration dates to minimize losses.
A call spread strategy involves buying and selling an equal number of call option contracts on the same underlying security. Because these are bought and sold with different strike prices and/or expiration dates, the amount you can potentially lose is reduced.
A downside? Potential profits are diminished as well.
With this strategy, you might buy one call option contract with a strike price of $115 per share and sell one contract for the same stock with a strike price of $120, for example. If both are in-the-money at the expiration date, you’ll make a profit on both investments.
Whether you’re a bull, a bear, or something in between, options trading — and specifically, call options — can be an effective type of investment to have in your portfolio.
Deciding to exercise a call option is your, well, call. Maybe you’ll fall in love with a stock’s performance, maybe you won’t. But at least you have the opportunity to make the choice.