How Do I Get Started with Call Options?

Introduction

Your investment strategy might be simple: buy stock in a good company with attractive earnings, growth, or dividend yield potential. Or, you hold several stocks or index funds in your account to spread risk, the old "eggs-in-several-baskets" approach.

You may want to start trading options, but get confused when scrolling through the options chain page. It's also possible that you came across the options page on accident, and left because you think they're only for the highly advanced trader.

Let's see if we can change your thinking with more details about how call options work.

‌

‌

An alternative to buying shares: Do more with less

Have you ever found yourself in either of these situations?

• When facing a stock market rally, you have to watch it from the sidelines due to limited funds.

You may not know that you can participate in high-priced stock shares even with a small account by buying calls.

‌

Call options give the buyer the right, but not the obligation, to buy 100 shares at a specified price. So, when you buy a call option, you're not buying 100 shares directly; you're simply buying a contract that affords you control of 100 shares of that stock.

‌

Suppose ABC stock is currently trading at $157.35. Buying 100 ABC shares would cost you $15,735 in total. Alternatively, if you choose to buy a call option on ABC, that would be a different story.

‌

Each contract generally covers 100 shares, so it would cost $608 to control 100 ABC shares. The call buyer would pay $608 in premium to get this in-the-money call (a call option is described as "in-the-money" or ITM if the market price is above the strike price). If he exercises the call option, paying another $15,500, the investor will receive 100 ABC shares. Therefore the average cost per share would be $161.08 (=$155+$6.08).

‌By understanding the basics, you may understand how buying a call option can be an alternative to purchasing a stock outright. However, there are inherent trade-offs and risks associated with options.

‌

Options do not last forever. If the ABC stock price is $154 at the expiration date of 19 August 22, the stock owner will have an open loss of $335 (=$15,735-$15,400, roughly 2.1% capital loss). He still keeps the ABC shares in his account and the potential upward gain in the stock.

If the contract is held through the expiration date, the investor will lose $608, or 100% of the premium paid to open the position. Of course, you don't need to hold it to expiration, and you can sell the calls back in the market anytime before it expires.

So how does a call buyer benefit from the rise in stock price? Let's check!

‌

Options enable leverage

Buying a house with a mortgage or purchasing securities by margin account are common ways to use leverage. Call options can allow a buyer to purchase shares at a lower price than the shares trade outright in the market. That's leverage at work. We must point out that the leverage effect in options trading doesn't mean you buy options on margin, rather call options can enable an investor to control more shares at a fraction of the current market price.

‌

Let's explore how leverage affects the profit and loss in trading options and buying the security on margin. Suppose there are three ways to establish a long position of ABC stock:

• Buy 100 ABC shares at $157.35, all in cash
• Buy 100 ABC shares at $157.35, half on cash and half on margin (a leverage ratio of 2:1)
• Buy one contract of ABC $155 19 August call at $6.08

‌

For simplicity, though, we suppose the buyer holds the call option to the expiration date, and no transaction cost evolved. In fact, margin interest is a significant consideration when using your margin account.

In both cases, it is not difficult to calculate the profit and loss number of owning stocks. Meanwhile, the margin account linearly scales up both profit and loss by the leverage ratio of 2:1 compared to the underlying price movement if there is no transaction cost. Using margin requires less upfront cash, which is why the percentage gain or loss is higher than simply buying stocks all in cash. As you would expect, leverage can amplify losses and gains.

‌

Nevertheless, a linear relation is not the case for options trading. If the price increases to $180, the 155-strike call option would allow the call buyer to purchase 100 ABC shares at $155. Therefore, the call buyer can earn a price spread of $2,500 by buying shares at a low price of $155 and selling them at a higher price of $180. Because the contract was initially purchased for $608, the net gain would be $1,829.

‌

If the stock price drops to $130, the call option will expire worthless. The call buyer will lose all of the $608 premium paid if the contract is held through expiration and not sold back into the market. Looking at the P&L in percentage, we would have a clearer picture of the leverage effect. Over 300% gain is achieved by purchasing a call option with less than a 15% rise in the underlying price. However, you might lose all your principal if the stock price moves against you.

‌

More differences

Although the call buying strategy is commonly known as the "stock replacement strategy," it's not a complete replacement. Before jumping into options as an alternative to stock, you should know a few things.

First, the buyer of a call option does not receive any dividends. The same is true of voting rights. Stockholders retain them; option holders don't.

‌

Every options contract has an expiration date, but you can hold a stock for as long as you'd like. When you buy a stock—particularly a long-term holding—you don't need to monitor it daily. Options require extra monitoring, especially as the expiration date approaches. After buying a call option, you need to be aware of expiration and the conversion of an option into stock if the option is exercised.

‌

‌

Let's recap

You can buy call options as a "stock replacement strategy," but the difference between stocks and options is more noteworthy.

• A call option entitles the buyer to purchase the shares at a pre-determined price over a certain period of time.
• Call options can allow investors to purchase shares at a lower price than they trade in the market. Call options also allow investors to profit from upward price swings without having to purchase the stock.
• Before investors decide to use options as an alternative to purchasing stocks, investors should understand the mechanics of options and the differences between each strategy.

‌

Practice can help you take your knowledge even further. Try out options paper trading now! >>>

Take a quiz to test yourself on our latest mobile version>>>

‌