- Buying calls and then selling or exercising them for a profit can be an excellent way to increase your portfolio’s performance.
- Investors often buy calls when they are bullish on a stock or other security because it affords them leverage.
- Call options help reduce the maximum loss that an investment may incur, unlike stocks, where the entire value of the investment may be lost if the stock price drops to zero.
When you buy a call, you pay the option agio in exchange for the right to buy shares at a situate price ( strike price ) on or before a certain date ( exhalation date ). Investors most often buy calls when they are bullish on a broth or early security because it offers leverage.
Reading: A Beginner’s Guide to Call Buying
For exemplar, assume ABC Co. trades for $ 50. A one-month at-the-money call choice on the stock costs $ 3. Would you rather buy 100 shares of ABC for $ 5,000 or one call option for $ 300 ( $ 3 × 100 shares ), with the bribe being pendent on the stock ’ s closing price one month from now ? Consider the graphic illustration of the two different scenarios below .
As you can see, the bribe for each investment is different. While buying the stock will require an investment of $ 5,000, you can control an equal issue of shares for merely $ 300 by buying a call option choice. besides note that the breakeven price on the stock trade is $ 50 per share, while the breakeven price on the option trade is $ 53 per partake ( not factoring in commissions or fees ) .
While both investments have unlimited top likely in the calendar month following their leverage, the potential loss scenarios are vastly different. case in point : While the biggest potential loss on the choice is $ 300, the loss on the breed purchase can be the entire $ 5,000 initial investment, should the share price plumb bob to zero .
Closing the position
Investors may close out their call positions by selling them back to the market or having them exercised, in which case they must deliver cash to the counterparties who sold them the calls ( and receive the shares in switch over ) .
Continuing with our exercise, let ’ s assume that the stock was trading at $ 55 near the one-month termination. Under this plant of circumstances, you could sell your bid for approximately $ 500 ( $ 5 × 100 shares ), which would give you a net profit of $ 200 ( $ 500 minus the $ 300 premium ) .
alternatively, you could have the call exercised ; in that shell, you would be compelled to pay $ 5,000 ( $ 50 × 100 shares ), and the counterparty who sold you the cry would deliver the shares. With this approach, the profit would besides be $ 200 ( $ 5,500 – $ 5,000 – $ 300 = $ 200 ). bill that the bribe from exercising or selling the shout is an identical net profit of $ 200 .
Call choice Considerations
Buying calls fee-tail more decisions compared with buying the implicit in stock. Assuming that you have decided on the stock on which to buy calls, here are some factors that need to be taken into circumstance :
- Amount of Premium Outlay: This is the first step in the process. In most cases, an investor would rather buy a call than the underlying stock because of the significantly lower cash outlay for the call. Continuing with the above example, if you have $1,500 to invest, then you would only be able to buy 30 ABC Co. shares at its current stock price of $50. But based on the one-month call price of $3, you would be able to buy five contracts (since each contract controls 100 shares, and would thus cost $300), which means you have the right—but not the obligation—to buy 500 shares at $50.
- Strike price: This is one of the two key option variables that need to be decided, the other being time to expiration. The strike price has a big impact on the outcome of your option trade, so you need to do some research on picking the right strike price. For a call option, the general rule is that the lower the strike price, the higher the call premium (because you obtain the right to buy the underlying stock at a lower price). The more out of the money the call, the lower the call premium. In this case, the strike price is at the money; i.e., it is equal to the stock’s current price of $50.
- Time to expiration: This is another key variable. For options, all else being equal, the longer the time to expiration, the higher the option premium. Deciding on the time to expiration involves a tradeoff between time and cost. Option contracts typically expire on the third Friday of each month.
- Number of option contracts: Once the strike price and the time to expiration have been finalized, you will have an idea of the call premium. With $1,500 to invest, and with each one-month $50 call option costing $300, you have to decide whether to buy five contracts for the full amount that you have available to invest, or buy three or four contracts and keep some cash in reserve.
- Type of option order: As a derivative of stock prices, option prices can be quite volatile. You would need to decide whether you should place a market order or a limit order for your calls.
What is the most I can lose by buying a call option?
For a predict buyer, the utmost loss is equal to the premium paid for the call .
What are the drawbacks of buying call options?
One drawback is that you have to get both key variables—the come to price and the time to expiration—right. If the underlying stock never trades higher than your strike monetary value before passing, or if it trades higher than the strike monetary value but merely after option death, then the call would expire “ despicable. ” Another disadvantage of buying options—whether calls or puts—is that they lose prize over time due to the termination date, a phenomenon known as meter 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 cases, no, it would be inadvisable to do thus. early exercise would result in the investor being unable to capture the call choice ’ south meter value, resulting in a lower acquire than if the call choice were sold. early use only makes sense in specific instances, such as if the choice is profoundly in the money and is approach passing, since fourth dimension measure would be negligible in this case .
Should I buy a call option on a very volatile stock if I am bullish on its long-term prospects?
Your call choice might be quite expensive if the stock certificate is very volatile. In accession, you run the hazard of the call run out unexercised if the stock does not trade above the strike price. If you are bullish on its long-run prospects, you might be better off buying the store rather than buying a call option on it.
The Bottom Line
trade calls can be an effective way of increasing exposure to stocks or other securities, without tying up a set of funds. such calls are used extensively by funds and large investors, allowing both to control large amounts of shares with relatively short capital .