How to Trade Call Options

The majority of casual investors buy and sell stocks.  If they are bearish on a stock, some will even short-sell stock.  But relatively few investors fully understand and take advantage of trading options. 

With stocks, you own a small piece of a company.  However, with options, you purchase the right to buy or sell underlying stock.  There are two basic types of options – calls and puts.  When you purchase a call option, you buy the right to purchase a stock at a specific price before a specific date.  When purchasing put options, you buy the right to sell a stock at a specific price before a specific date.  Like stocks, you can both buy and sell options. 

Traders consider buying call options when they are bullish on an underlying stock.  As the stock rises, call options, in general, also rise.  There are, though, some important differences between buying an underlying stock and its call options.  First, options are cheaper than buying the underlying stock.  If you a share of XYZ is $100, it may cost you the same to control 1000 shares with options.

Options are cheaper because they have a strike price and an expiration date.  The strike price of a call option is the price at which you have the right to purchase the stock.  If the price of an underlying stock is above the strike price, the call option is considered “in-the-money.”  If the price of the stock is below the strike price, the call option is “out-of-the-money” while it is “at-the-money” if the stock is the same price as the strike price.  Call options that are in-the-money have inherent value.  For example, let’s say the price of stock XYZ increased to $105.  You, however, own a call option with a strike price of $100.  You thus have the option to buy XYZ at $100 while selling it for $105.  This in-the-money call option thus as an inherent value of $5.  Call options that are at-the-money do not have any inherent value.  For instance, it would not be worth it to exercise a call option with a strike price of $15 because you cannot sell it for a profit.  Call options that are out-of-the-money actually have a negative inherent value since the stock would have to rise just to get to the strike price.  The farther the stock price is from the strike price, the lower the inherent value. 

The expiration date is the time until which you have to exercise your option.  Because options expire, they have a time value.  As the expiration draws nearer, the time value of call options decrease because there is less time for the underlying stock to increase in value.  A call option that expires in a year will therefore have much greater time value than a call option that expires in a week.  The price of options are roughly calculated by:

                  Option price = inherent value + time value

There are several exit strategies with call options.  If you do nothing and let an option expire, call options that are at-the-money or out-of-the-money will become worthless – they will have no inherent or time value.  However, if a call option is in-the-money at expiration, you can exercise your option for a profit.  Many option trading companies will automatically exercise options that are in-the-money at expiration for you. 

Most option traders, however, have no intention of ever owning the underlying stock.  Traders often sell their options well before expiration.  Call options, in general, increase in value with the underlying stock.  Thus, if a stock rises, you can usually sell a corresponding call option at a profit. 

This can be beneficial because it leverages your capital.  Let’s say you have $1000 to invest.  If a share of XYZ costs $100, you can buy 10 shares.  However, a call option of XYZ, with a strike price of $100, costs only $10.  You can thus alternatively purchase 100 call options of XYZ.  If shares of XYZ go to $105 at expiration, owning the stock would give you a profit of $50.  Owning the options, however, would give you a profit of roughly $500.  The risk in call options, however, is that this increase in price needs to occur before the expiration date. 

For more information about trading options, visit DayTradingModels.com