Many investors are unfamiliar with options as an investment and specifically don't know how to take advantage of call options trading. But it needn't be that way. Options can be a great way to participate in an stocks upside while limiting the risk of outright ownership in the stock.
The video on the right will give you a quick overview on the dynamics of call option investing.
Why Use Call Options?
It's all about risk. When you buy 100 shares of a $50 stock, you have $5000 tied up with potential to lose some or all of it. On the other hand, buying an option contract on that same stock will tie up much less money. The premium that you pay can be two or three dollars in many cases (usually multiplied by 100 as that is the number of shares as part of the contract). This means that all you are risking is the premium which would be no more than $200 to $300 in this example.
There are two main types of options: calls and puts. I will only deal with call options as it get s too cumbersome to flip back and forth between the differences.
You can look at a call option as an agreement between two parties (via an exchange). The terms of the agreement are:
- Which stock to buy and how many shares (the standard is 100)
- The price that will be paid (referred to as the Strike Price)
- The time period (given as an expiration date)
- The premium - this is the cost to own the contract or agreement
There are typically three parties involved in the transaction:
- The seller of the contract (or the writer)
- The buyer of the contract (the holder)
- The exchange that manages ensures that agreements are honored. It could be argued that the brokerage are another party but I'll keep them out for simplicity.
Motivation of Both Parties
Call options are a bullish instrument. This obviously means that the holder of the option believes that the price of the underlying stock (the stock on which the option was written) will go up. The writer believes the opposite. He believes the price of the stock will go down.
The following are the outcomes that can occur during the life of the contract:
- The price of the underlying stock goes up
- The price of the underlying stays the same as when the option contract was written.
- The price of the stock goes down.
The Price of the Underlying Stock Goes Up
This scenario will make the holder of the option (buyer) very happy. Of course, it needs to be stated that the price of the stock has to go higher than the strike price plus the premium. This is referred to as the break even point. Note: this does not account for commissions for any leg of the transactions!
Advanced Concept: feel free to skip over this little tidbit. When a stock makes a move (especially a big move), it's volatility will change. This volatility affects the price of the option in a big way. The price may even move well above (or below) what would be expected relative to the stock price.
The Price of the Underlying Stock Stays the Same
This scenario is not good for the holder. It is great for the option writer. The stock will not have moved high enough to offset the amount of premium the holder paid. Therefore, the option has the risk of expiring worthless.
Note: options contracts have value in and of themselves. Therefore, the holder does have an option (no pun intended) to close out (sell) his position in the contract. He will likely have to sell it for a loss but at least he can recover some of the value. This is one way to keep losses at a minimum.
The Price of the Underlying Stock Drops
This is the worst case scenario for the holder of the option. There will most likely be no value left. Even the contract itself will have little value (it will be so small it would cost more in commissions to realize any value at all). This is the best scenario for the option writer.
Another important point - option contracts are handled by an exchange. Therefore, buyers and sellers are not known to each other. Closing out a position will likely not be with the person you opened it with.
The term exercise refers to executing the terms of the contract. It means that the underlying stock price has moved enough for the seller to want to buy the underlying based on all of the conditions of the contract.
As an example, suppose XYZ stock is selling for $20. A buyer buys a contract for XYZ stock where the terms are as follows:
- Number of Shares: 100
- Strike Price: 20 - note the buyer can choose other price points as long as they are on the market!
- Expiration date: one month later - the buyer can choose other expiration dates as long as they are available on the market.
- Premium: $1.85
This would mean that the buyer pays a premium of $1.85 x 100 = $185 for the right to buy XYZ stock anytime before of on the date of expiration.
Note: Unlike American Options European Options must be held to expiration!
At the time of expiration, XYZ stock is $8 higher for a price of $28. The holder decides to exercise his option. He alerts his broker that he wishes to exercise the option and pays $20 x 100 = $2000. He now owns XYZ stock. The seller must buy it from him for that price. This is all handled via the exchange.
In the event some seller could not buy it, the exchange will step in and buy it and deal with the seller on its own to reclaim the amount.
The holder has two choices at this point. He can keep the stock or he can turn around and immediately sell for $28 (x 100). This will net him an $800 gain.
If the seller decides to keep the stock, his risk profile immediately changes and is at risk should the price of the stock below $2185. ($20 strike + $185 premium). This is an important distinction. If the seller simultaneously sells the stock for the market price, his only risk at that point was the premium paid!
This article is not intended to try and convince you to start investing in options. There is much more to them and when not used correctly can be very risky. Therefore, please do not misconstrue this as investment advice in anyway, shape, or form! It is advisable to consult with a professional money manager or financial adviser before embarking on any investment.