A Beginner’s Guide to Call Buying

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A Beginner’s Guide to Call Buying

The widely held belief that 90% of all options “expire worthless” scares investors into thinking that if they purchase options, they would lose money 90% of the time. However, according to Cboe Global Markets (Cboe) and the Options Clearing Corporation (OCC), only approximately 23% of options expire worthless, 7% are exercised, and the remainder, slightly under 70%, are traded out or closed by forming an offsetting position.

Key Takeaways

  • Buying calls and then selling or exercising them for a profit might be a great method to boost the success of your portfolio.
  • When investors are optimistic on a stock or other investment, they often purchase calls to gain leverage.
  • In contrast to stocks, where the whole value of the investment may be lost if the stock price falls to zero, call options assist restrict the maximum loss that an investment may suffer.

Call-Buying Strategy

When you purchase a call option, you pay the option premium in return for the right to purchase shares at a certain price (strike price) on or before a specific date (expirationdate).Because calls provide leverage, investors often purchase them when they are optimistic on a stock or other investment.

Assume ABC Company is valued at $50. The stock’s one-month at-the-money call option costs $3. Would you rather purchase 100 ABC shares for $5,000 or one call option for $300 ($3 100 shares), with the payout based on the stock’s closing price one month from now? Consider the visual representations of the two situations below.

Image by Julie Bang © Investopedia 2019

As you can see, each investment has a distinct payback. While purchasing the stock requires a $5,000 investment, you may control an equivalent number of shares for just $300 by purchasing a call option. Also, the stock transaction has a breakeven price of $50 per share, but the option trade has a breakeven price of $53 per share (not factoring in commissions or fees).

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While both assets have infinite upside potential in the month after purchase, the loss situations are radically different. For example, although the maximum possible loss on the option is $300, the maximum potential loss on the stock purchase is the whole $5,000 original investment if the share price falls to zero.

Closing the Position

Investors may exit their call holdings by selling them back to the market or having them exercised, in which case they must pay the counterparty who sold them the calls cash (and receive the shares in exchange).

Continuing with our example, suppose the stock was trading at $55 as the one-month expiry approached. Under these conditions, you might sell your call for about $500 ($5 100 shares), giving you a net profit of $200 ($500 less the $300 premium).

You may also exercise the call, in which case you would be required to pay $5,000 ($50 100 shares) and the counterparty who sold you the call would deliver the shares. The profit with this method would likewise be $200 ($5,500 – $5,000 – $300 = $200). It is worth noting that the reward from exercising or selling the call is the same: a net profit of $200.

Call Option Considerations

Purchasing calls requires more considerations than purchasing the underlying stock. Assuming you’ve decided on the stock for which you want to purchase calls, here are some things to think about:

  • The cost of the premium: This is the first stage in the procedure. Because of the substantially smaller financial outlay for the call, most investors would prefer purchase a call than the underlying stock. Continuing with the previous example, if you have $1,500 to invest, you can only purchase 30 ABC Co. shares at the current stock price of $50. However, based on the one-month call price of $3, you would be able to purchase five contracts (each contract controlling 100 shares and hence costing $300), implying that you have the right—but not the obligation—to purchase 500 shares at $50.
  • The strike price is one of two major option variables that must be determined, the other being the time to expiry. Because the striking price has a significant influence on the success of an option trade, you should do some research to determine the best strike price. The basic rule for call options is that the lower the strike price, the bigger the call premium (because you obtain the right to buy the underlying stock at a lower price).The smaller the call premium, the more out of pocket the call. In this scenario, the strike price is at the money (equivalent to the current stock price of $50).
  • Another important element is the time to expiry. All else being equal, the longer the period to expiry for options, the larger the option premium. Choosing an expiry date necessitates a balance between time and expense. Typically, option contracts expire on the third Friday of each month.
  • The number of option contracts will be determined after the strike price and the time to expiry have been determined. With $1,500 to invest and each one-month $50 call option costing $300, you must determine whether to purchase five contracts for the whole amount or three or four contracts and retain some cash in reserve.
  • Type of option order: Because option prices are a derivative of stock prices, they may be highly volatile. You must select whether to put a market order or a limit order for your calls.
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What is the most I can lose by buying a call option?

The maximum loss for a call buyer is equal to the price paid for the call.

What are the drawbacks of buying call options?

One disadvantage is that you must get both critical variables correct—the strike price and the time to expiry. If the underlying stock never goes higher than your strike price before expiration, or if it climbs higher but only after option expiration, the call will expire “worthless.” Another downside of purchasing options, whether calls or puts, is that their value depreciates over time owing to the expiry date, a process known as time decay.

Is it advisable to exercise my call option if it is in the money and there are a few weeks remaining for expiration?

In most circumstances, it would be unwise to do so. Early exercise would prevent the investor from capturing the time value of the call option, resulting in a lesser gain than if the call option was sold. Early exercise makes appropriate only in certain circumstances, such as when the option is deeply in the money and close to expiry, since time value is low in this situation.

Should I buy a call option on a very volatile stock if I am bullish on its long-term prospects?

If the stock is very volatile, your call option may be rather pricey. Furthermore, if the stock does not move above the strike price, the call will expire unexercised. If you believe in its long-term potential, you may be better off purchasing the stock rather than a call option on it.

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The Bottom Line

Trading calls may be a good method to increase your exposure to stocks or other assets without committing a lot of money. Such calls are often utilized by funds and major investors, enabling both to control enormous quantities of shares with a little amount of cash.

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