A call option is a contract that gives the owner the right to buy stock at a specific price (the strike price) at some time in the future. The period of time could be as short as a day or as long as a couple years, depending on the option. The cool thing about buying an option is you have the right, but not the obligation, to buy or sell that stock.
The upside of a call option is theoretically unlimited, while the downside is limited to what you paid for the option.
Remember that each call option contract gives its holder the right to buy 100 shares of the underlying security at the strike price. So if the quoted price of the call is $1.50, it will cost you $1.50 * 100 = $150 to purchase one contract*.
Trading a Call Option
The call buyer is bullish on the underlying security and is looking for a way to get leverage. There are two ways to play this:
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If you plan to hold the option until expiration, then you will need the price of the underlying stock to increase in excess of the option premium before the expiration day. The buyer is typically looking for leverage.
- You can plan to hold the option short term in anticipation of a quick but more modest upwards move in the underlying stock price. In that case, even though the stock price didn't move up as much as the options premium, you can quickly sell the option back to the market and make a potential profit.
Picking a Call Option
There are three variations of a call based upon where the strike price is relative to the current market price of the underlying security.
In the money: If a call option's strike price is below the current market price of a stock, it is considered to be in-the-money. The deeper in the money, the higher the cost of an option contract. That's because the percentage of premium that will be in the form of intrinsic value
- value that can be immediately converted into revenue on exercise - is higher. On the other hand, the time-value of the option will also diminish as the strikes go deeper in the money. The Delta of the option (the predicted percentage change of the price of the option relative to a one point change in the underlying stock) will be higher, reflecting a high probability that the position will make at least one penny of revenue at expiration. Remember that while Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
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There may not be much advantage to buying an option deep-in-the-money versus just buying the stock - particularly with lower priced stocks.
At the money: If a call option's strike price is at the current market price of a stock, it is considered to be at-the-money. If you buy an at the money call option, then you only need the stock price to increase by the option premium to turn a profit.
Out of the money: Out of the money options are typically the cheapest because the chance that they will expire in the money is lower. In that sense, out of the money options give investor higher leverage (it costs you less to control 100 shares of stock) but are more speculative.
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Buying too far out of the money is very speculative and has potentially higher rewards but much lower probability of success.
How to Finish
At any given time before expiration, a call option holder can sell the call to close out the position. This can be done to either realize a profitable gain or to cut a loss. Alternatively, if the option is at least $0.01 in-the-money it will be automatically exercise and you'll now own the underlying shares. Be careful that you have enough buying power in your account if this happens. If you don't, they will likely be sold by your broker immediately regardless of the prevailing price for that security.
*These examples omit the costs associated with trading options, and you'll need to figure that into your overall returns. At Zecco Trading, options commissions are just $4.50 per trade and $0.50 per contract.