Buying Call Options

On this page we will learn the facts about buying Call Options and some possible strategies. I’ve bought many options in my trading days but selling options will always be my #1 strategy. You will see me buying options more than selling when the market is moving up. When the market is moving up, if I sell options, it will be with Covered Calls. I’ll bring in a premium in addition to making money on the stock assignment. If the market is moving up you don’t want to sell Naked Calls. Selling Naked Calls in an up market can be a very dangerous game.

Before you start this page, make sure you understand the following terms: Long & Short Position, Strike Price, Expiration Date, Intrinsic Value & Time Value, Time Decay, Premium, Exercise, Assignment (Assignment notice), In, At and Out-of-the-Money. Also, you must understand the difference between rights and obligations.

There are 2 types of stock options. A “Call Option” and a “Put Option.” In many books, and on this site, they are sometimes referred to as “Calls” and “Puts.” A stock option is a contract between a buyer and a seller. With a stock option’s contract, there is a time limit to the option, which is stated in the options contract. A Call Option is a contract between a buyer and a seller that gives the option buyer the right, but not the obligation, to buy an agreed quantity of stock. A Put Option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to sell an agreed quantity of stock. In this section we will only be talking about Call Options, more specifically buying Call Options.  A Call Option contract includes the amount of stock involved (agreed quantity), an Expiration Date which specifies the limited time frame in which the buyer has to purchase the stock, a Strike Price which is the price the option buyer will pay for the stock if he exercises his right to buy the stock, and the Premium, which is the fee the buyer pays the seller for the contract.

Buying options should be a little easier to understand than selling options because buying options is done in an order we are accustom to. We “Buy to Open” the contract, then “Sell to Close” the deal. Buy low, then sell high! With selling options it’s done in the opposite order, a little harder to understand. Sell first, then “Buy to Close” the deal. Buying options is getting into a long position, you own something! Buying options is a bullish strategy. An option buyer is hoping for the underlying stock to move up, hopefully move up fast! Buying options is a good way to start trading options if done with a lot of care and with small quantities. It’s a great way to learn how Time Decay works; how the value of an option erodes quickly with time. When buying options you will learn quickly because you will feel the pain of Time Decay if your stock doesn’t move up quickly.

Most beginners start out with the purchase of Call Options. The appeal is that for a very small amount of cash at risk, potential returns can be rapid and impressive. It is very possible to buy a Call Option for as little as $500 and see it double to $1000 in a matter of days, or in some cases, hours. Buying options is not simply a way to double your money; it is more likely a case of doubling your money or losing your entire investment. Something you must remember, 80% of all option contracts expire worthless. This is a FACT! They expire worthless because of greed and a lack of education, and the understanding of Time Decay and the erosion of the Time Value of the option. The main reason buying options is a difficult strategy is you must pinpoint the direction of the stock and the stock must move up (in the case of buying a Call) in the time allotted in the option’s contract. As soon as you purchase an option, the “Time Decay” starts to work against you because the Time Value part of the option’s value starts to erode immediately. Because of this Time Decay problem, my recommendation is if you buy an option and the stock moves down, get out fast, especially if it’s a very short term option (less than a month). Do not wait for the following week for the stock to go up because the Time Value is decreasing fast. Time Decay accelerates as you get closer to the Expiration Date. You buy an option because you feel it’s going up NOW! If you got the direction wrong, sell your option and move on to the next deal. Do not let the value of the option go down to zero.

There is a general case where buying long options makes a lot of sense, and it involves stock you already own. This case is a disciplined approach to portfolio management, because it’s not motivated purely by speculation. This is a case where I would buy an option. The only difference between me and other option’s traders is I like to buy options with a longer life span. I buy options with Expiration Dates out 3 or 4 months. With this case many traders will buy options with an Expiration Date out a few weeks or a month. I’ll spend a little more for my option but I’ll have more protection from Time Decay.

The stock’s price of a stock you own has fallen sharply on recent news or in response to a broader market trends, and you expect the price to rebound. Also, if the price falls below its established trading range as a result of unexpected bad news, a rumor, or broader market trends. For example, a company may announce that it doesn’t expect to meet its current quarter’s earnings target. This is not necessarily a sign of bad things to come, but it is likely that the stock price will overreact to the news by falling below its trading range. If you believe that this will be a temporary move and you expect the price to return to its established levels within a few days, you can use the strategy of buying options to take advantage of the price movement.

Note that I would use this long strategy for a very short term option. Me personally, again, I would buy an option out 3 or 4 months with the Expiration Date but only stay in the option short term. I want to get out before Time Decay hurts me. Most traders who hold long options over several months struggle with declining Time Value, often losing money even if the stock doesn’t go down. Of course the option will lose value if the stock goes down, but Time Decay will erode your option if the stock stays even, or when the underlying stock goes up slightly. This long Call strategy is intended for a very short term, because it’s designed to profit from price movement within a few trading secessions.

With this common strategy, the Call Option should be bought At-the-Money. This means if the stock is trading in the area of $20, buy the option with a $20 Strike Price. These options will most likely move 50¢ or more for every $1 movement in the stock price. This is the option’s Delta. Delta measures how much an option’s price is expected to change per $1 change in the price of the underlying stock. Many traders buy options near expiration because they have little Time Value; maybe a month or less. This means they are cheaper and will be more responsive to the stock price movement. Get in and out quickly. Remember, if you trade like most traders, you are trading here on little Time Value and little Intrinsic Value for the most part, and the option will expire in a few weeks, so this a very short term strategy designed to take profit and get out. If the stock does not move in your desired direction fast, you must also get out with what you can. I do not recommend buying very short term options. I like to go out a little further with my Expiration Date for more protection. 

Below we will look at a few reasons or strategies why traders might buy Call options. But first we’ll take a look at an example of an option’s order form when buying an option.

Buy to Open 10 YELP 8/12/16 $32.50 C @ $1.50 (+$1500)

This is a real life example. I looked at this option on Monday, August 8, 2016. I did not buy it but I did look at it! As you see in this order form this is a buy order (Buy to Open). It’s for 10 contracts (1000 Shares). The stock involved is Yelp. It was to expire the Friday of that week, which was August 12th. When I looked at the option in the middle of the day on Monday, the stock was at $32.40. An At-the-Money option was the Strike Price I looked at, $32.50. The reason I looked at this option is Yelp’s earnings were coming out on Tuesday the 9th and I was curious how this option would do because I felt the earnings were going to be good. Also I was curious because I was involved in Yelp, I owned 5000 shares of the stock. I also had a Call sold against these shares. Take a look at my Trade History (8/9/16). The (C) means it’s a Call Option. The premium ($1.50) was very high to buy this option because earnings were due out, high volatility. The total premium to be paid for the 10 contracts (the right to buy 1000 shares) is $1500.

Speculation

One of the reasons traders buy options is pure speculation. Speculation, by definition, requires a trader to take a position in a market where he is anticipating whether the price of a security or asset will increase or decrease. Speculators try to profit big, and one way to do this is by using derivatives that use large amounts of leverage. This is where buying options comes into play. Speculating with the buying of options is basically risking money on ideas or guesses about something that is not known in hopes for a large reward. In the Yelp example above, this trade would have been a speculation trade. It would have been riding on the earnings report while the results of the report is totally unknown.

Now that time has passed we know the result of the Yelp earnings report, so let’s take a look at how this speculation trade would have played out had we bought the option.

On Tuesday, August 9th, after the close, Yelp released their earnings. The report had Yelp beating the “Street’s” estimates and the stock went up. On Tuesday, the 9th Yelp closed at $32.63. On Wednesday, the 10th the stock opened at $36.17 and on the 10th Yelp closed at $36.80. At the close, 1 day after the earnings announcement, Yelp was up $4.17. On Friday, Expiration Day the stock closed at $38.45. At this point, if I bought this option, I would be able to buy the stock at my Strike Price of $32.50. I could hold the stock or turn around and sell the stock at the price the stock is now at, $38.45. If I did that I would have made $5.95 per shares on the deal. $5.95 on the 1000 shares is $5950 on a $1500 investment, in 5 days. This is not what most option traders do. Most would just sell the option with a “Sell to Close” and make the same profit. Again, Call buyers can close their positions without having to buy the stock first and then sell it, and closing the position in this way (by selling the Call) would lead to the same profit. This would have been a great option to buy but looking at it I was just teasing myself because I don’t buy short term options!

Leverage

Leverage can be very powerful when it comes to investing because by using leverage it’s possible to turn relatively small amounts of capital into significant profits. With many financial instruments, such as stocks, the only way to take advantage of leverage is to borrow funds to take a position and this isn’t always possible for everyone. This is with a brokerage margin account. With some instruments, though, leverage is possible in other ways.

One of the biggest benefits of trading options is that options contracts themselves are a leverage tool, and they allow you to greatly multiply the power of your starting capital. On this page we look at exactly how leverage works in options trading.

Buying options contracts allows you to control a greater amount of the underlying stocks than you could by actually trading the stocks themselves. Put simply, if you had a certain amount of capital to invest then you can create the potential for far higher profits through buying options than you could through buying stocks.

This is essentially because the cost of options contracts is typically much lower than the cost of their underlying stock, and yet you can benefit from price movements in the underlying stock in the same way.

Let’s assume that you had $1,000 to invest, and you wished to invest in Company XYZ stock because you believed it was going to increase in price. If Company XYZ stock was trading at $20, then you could purchase 50 shares in Company XYZ with your $1,000. If the stock went up in value, then you would be able to sell those shares for a profit. For example, if they went up by $5 to $25 then you could sell them at $5 profit per share for a total profit of $250.

Now let’s assume you decided to invest in call options on Company XYZ Stock, trading at $2, with a strike price of $20. One contract size was 100 shares. You could buy five contracts at $200 each: meaning you effectively have control over 500 shares in Company XYZ (5 contracts, each covering 100 shares). This would mean that using your $1,000 to buy options has given you control of 10 times as many shares as using your $1,000 to directly buy shares at $20 per share. With the price of Company XYZ going up to $25, you would make a lot more money through selling your options at a profit than the $250 you would make in the example above.

That is essentially the principle of how leverage in options trading works, in very simple terms. This should illustrate why it’s possible to make significant profits without necessarily needing a lot of starting capital; which in turn is why so many investors choose to trade options. To fully grasp how leverage works and is calculated with options you must study Delta. Delta measures how much an option’s price is expected to change per $1 change in the price of the underlying stock.

Here’s another way a trader or investor will use buying options. If you already own a stock, you can use call options to boost leverage in the stock, or as a fail-safe device. If you bought XYZ at $20 and it’s now at $40, you’re probably thinking of selling and locking in those gains; unfortunately, you believe the stock is going to continue to go up. No problem. Sell your stock and buy a call option at $40. You’ve locked in your gains, minus the cost of purchasing the call, and you can still take advantage of any upside movement.

Hedging

One of the simplest ways to explain this technique is to compare it to insurance; in fact insurance is technically a form of hedging. If you take insurance out on something that you own: such as a car, house, or household contents, then you are basically protecting yourself against the risk of loss or damage to your possessions. You incur the cost of the insurance premium so that you will receive some form of compensation if your possessions are lost, stolen, or damaged, thus limiting your exposure to risk.

Using options for hedging can also be part of some complex trading strategies. See below. Hedging with buying options can also be with a single, stand alone option. For example: If you own 1000 shares of XYZ stock, you might protect yourself from the stock going down by buying 10 contracts of a Put Option on the same stock. If XYZ stock goes down, the Put Option you purchased will increase in value to offset the lose incurred from the stock going down.

Also, if you are Short 1000 shares of XYZ stock you might buy 10 contracts of a Call Option on the same stock. If the stock goes up your short position will lose value. However, your Call Option you bought will increase in value. This hedging with buying options is insurance against your initial investment going against you. Many traders buy options to hedge!

Spreads/Combination Trades

When a trader gets involved in Combination trades he will get involved in buying options. Using Combination trades is a much safer situation than buying options as a stand alone position. Combination or Spread trades are normally traded by more advanced traders because they take more knowledge of the options market to execute correctly. Combination and Spreads are trades composed of one or more Calls and one or more Puts. While the original Combination or Spreads are sold as a single unit, each part may be sold or exercised individually.

Option Combinations span a wide range of broad strategies which include Spreads, Collars, Straddles and Strangles. There are then more specific strategies as the Iron Condor, which involves buying and holding four different options with different strike prices. One disadvantage of such strategies, however, is the commission costs incurred, especially for more complex strategies that involve the simultaneous purchase and sale of a number of options.

All of these combination trades involve the buying of options. There are many reason why a trader will buy options but buying options just to speculate is something I never do. The leverage factor makes it very attractive; controlling more stock for less money, however, the risk is just too much for me. For me, selling options and having Time Decay on my side is where I want to be. With buying options, Time Decay is your enemy!