Investing isn’t unlike a martial art. Victors are decided not by brute force, but by reaction time and technique.
Call options are one such technique that when applied correctly can lead to a nice profit. BUT (and that’s a big but), like any investment, if you miscalculate (which is easy to do), you’re out a lot of money.
That’s exactly why call options are for advanced investors that know how to time the better than your average newbie buyer.
What is a call option?
A call option is a contract that gives you the option, but not the obligation, to purchase a stock, bond, commodity, or other security at a locked-in price within a certain time limit.
Here are a few of the various terms you’ll need to know when it comes to buying calls:
- The strike price is the price of each share within the call option.
- The premium is the price of the call option contract itself.
- The expiration date is the date on which the call option expires, usually a week, month, three months out.
Let’s say TSLA is selling at $100. You think it’s going to go up to $120, so you purchase a call for a of $100 and an of $3 per share.
Remember, you’re not buying the stock yet, just the right to buy 100 shares at $100 per share. So you’ve just paid $3 x 100 = $300 for the call option. The expiration date is three months out, so you have some time to watch the market’s volatility.
TSLA rises to $120 as you had predicted, so you execute on your call option and purchase your 100 shares at $100. Let’s do the math to see how you made out.
- Your premium total for the call option was $300.
- Your strike price for the TSLA shares is $100 x 100 = $10,000.
- So in total, you’ve paid $10,300.
- Your shares are now worth $120 x 100 = $12,000.
- So you’ve made $12,000 – $10,300 = $1,700.
If you’d put more serious money on the table and purchased 10 call options for $100,000 plus a premium of $3,000, your profit would’ve gone up by 10x = $17,000. right there.
How is a call option different from a put option?
A put is simply the reverse of a call . It’s a that you pay a small for in order to get the right, but not the obligation, to sell the at a certain point within a certain time limit.
What is a covered call?
A covered call is when you sell call options on stocks that you actually own. Covered calls are used to make a little extra income on the stocks in your portfolio that you think will remain steady or even drop, while others think they’ll increase.
For emphasis, covered calls are “covered” because you actually own the shares and are able to sell if the holder of your call option chooses to execute their right to buy (in contrast to a short call, defined below).
Let’s say you own 1,000 shares of AAPL at $100 and sell call options for a strike price of $110 and a premium of $3. Another buyer thinks that AAPL is about to skyrocket, so they purchase all 10 of your call options.
Remember: you haven’t sold them the shares yet, just the right to buy them if they choose to execute on the option. You’re betting that shares of AAPL will stay steady or drop and the buyer won’t buy. The buyer, by contrast, is betting that your shares will increase in value enough to offset his premium and strike price.
Turns out, AAPL doesn’t rise above $105 by the expiration date, so your buyer allows the options to expire. Your covered call paid off. You keep your shares and the buyer’s premium of $3 x 1,000 = $3,000.
What is a long call?
A long call is when you purchase a call option because you believe that prices will eventually rise before the expiration date.
In the example above, the buyer of your call options was making a long call. They believed that the prices of AAPL would rise high enough to offset both their premium and the strike price by the expiration date. In this case, the strike price was higher than the current market value, meaning the call option was “out of the money”.
If AAPL had risen to, say, $150 before the expiration date, they would’ve executed on their call options to purchase 1,000 of your shares at $110 = $110,000. Factoring in their premium of $3,000, they paid you $113,000 for 1,000 AAPL shares now worth $150. Their total profit is $150,000 – $113,000 = $37,000. Their long call paid off.
What is a short call?
If a covered call is selling options on shares that you currently own, a short call is selling options on shares that you don’t currently own. It’s a high-risk strategy that advanced investors and hedge funds might use to sway the market, make premiums, and lower a stock price.
To use a realistic (if unscrupulous) example, let’s say the market indicates that shares of Xeris Pharmaceuticals are about to skyrocket in value from $100 to $200 thanks to a new miracle drug. You believe that the drug will get rejected by the FDA, so you offer 100 short calls for $150 at a premium of $5 and an expiration date of 1 month.
You’re telling the market “I promise to sell you 10,000 shares of XERS at $150 within the next month, for an upfront premium of $50,000.”
The market thinks you’re nuts and buys up all 100 of your call options. You immediately net 100 x 100 x $5 in premiums, or $50,000.
In Scenario one, let’s say the drug gets rejected and XERS shares plummet to $50. Nobody executes on your calls, so get to keep the $50,000 of premiums.
In Scenario two, let’s say shares of XERS did rise to $200 by the expiration date. All of your buyers execute on their options, but you don’t have the shares to sell them. You now have to buy up 10,000 shares at $200 and re-sell them for the strike price of $150 to your call buyers. Your net loss (minus commissions et al) is 10,000 x ($200 – $150) = $500,000, minus your premium of $50,000 = $450,000.
This example illustrates why short calls are so risky. The maximum upside of short calls is the premium only, or in this case, $50,000. But the downsides are limitless; if XERS had skyrocketed to $1,000 per share, you’d be out millions.
Are call options safer than other investments?
Call options are often considered a very risky . They’re inherently complex, and because they’re more commonly traded by advanced investors and institutions backed by limitless market data, amateurs can quickly find themselves in the red facing a lot of .
While it’s great to understand the basics of call options, don’t consider them until you’re a more experienced . There’s a lot of on the line if you don’t know what you’re doing. You’re better off sticking with a less risky such as a .
When are call options useful?
There are three common reasons why more advanced investors might leverage call options (again, I need to reiterate that this is not the right investment for beginners).
Selling options is a quick way to make a few bucks off of your existing assets. As illustrated in the example above, you can sell a covered call on stocks in your portfolio that you believe will stay steady or even lose a little value. There are tools out there like E*TRADE‘s Options Income Finder that can help you ID shares in your portfolio that are ripe for passive income generation.
Plus, selling calls with a strike price above the current market price is a low-risk income-generating strategy; even if your buyer’s long call pays off and they execute their right to buy, you’ve still netted their premiums plus the difference in your purchase price and strike price.
Call options also give you the ability to “invest” in a stock without having to purchase shares upfront.
Let’s say you foresee shares of TSLA skyrocketing, but you need some time to save or sell off your other positions to afford some TSLA. You can lock in a decent strike price by paying a few hundred bucks in premiums today and buy yourself some time. Later, if TSLA doesn’t rise like you thought it would, you can simply let your options expire.
Call options are also a common way a can prevent a “taxable event” through realized gains.
Let’s say you need to squeeze some income out of your 100 shares of AMZN. You could sell, but you’ll be subject to commissions and capital gains taxes on your newly-realized gains.
So instead of selling your position, you can sell a covered on your shares. In this case, the only cost to you, the , is the time and legal bill for setting up the . Many (aka, online brokers) can set up options contracts for a low fee, and once your picks them up, you can reap in the right away.
Call options are that can be leveraged to squeeze a little extra income out of your existing portfolio and help you invest in the without having to purchase shares upfront.
Make no mistake; is an advanced investing technique (maybe not a black belt, but perhaps a yellow belt right in the middle). It’s worth reiterating, too, that short calls can put you at for little immediate upside, so they’re not at all right for the beginner .
But if you learn the ropes and take it slow, options trading can make your portfolio go a little further.
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