The widely held misconception that 90% of all options expire worthless 22% of the time terrifies investors into mistakenly believing that they will lose money 90% of the time if they purchase options. However, based on their research, the Cboe Global Markets (Cboe) and the Options Clearing Corporation (OCC) estimate that, of all the options, only about 2023 percent expire worthless, while the remaining 77 percent are exercised and the majority, just under 2070 percent are traded out or closed by creating an offset position.
Buying calls is a popular options strategy that can be used to profit from rising stock prices. But how do buy calls work exactly? This guide will answer all your questions about call options, from the basics to more advanced concepts.
What are Call Options?
A call option is a contract that gives the buyer the right, but not the obligation, to buy a certain number of shares of an underlying security at a predetermined price (known as the strike price) on or before a specific date (the expiration date) The buyer of the call option pays a premium to the seller of the option in exchange for this right.
Here’s an example:
- You believe that the stock price of ABC Company will increase in the next month.
- You purchase a call option on ABC Company with a strike price of $50 and an expiration date of one month from now.
- The premium for the call option is $3 per share.
- If the stock price of ABC Company rises above $53 per share before the expiration date, you can exercise your option and buy the shares at $50 per share. This would result in a profit of $3 per share, minus the premium you paid.
- If the stock price of ABC Company falls below $50 per share, you can choose not to exercise your option and let it expire worthless. In this case, you would lose the premium you paid.
How to Buy Calls
Buying calls is a relatively simple process. You can buy calls through a broker or online trading platform. Here are the steps involved:
- Choose the underlying security: Decide which stock, ETF, or other security you want to buy a call option on.
- Select the strike price: Choose the strike price that you believe the underlying security will trade above by the expiration date.
- Choose the expiration date: Select the expiration date that gives you enough time for the underlying security to reach your target price.
- Place your order: Enter your order to buy the call option through your broker or online trading platform.
Advantages of Buying Calls
There are several advantages to buying calls:
- Leverage: Call options offer leverage, which means that you can control a larger number of shares of the underlying security with a smaller investment.
- Limited risk: The maximum loss you can incur when buying a call option is the premium you paid.
- Potential for unlimited profits: If the underlying security price rises significantly, your profits can be unlimited.
- Flexibility: You can buy calls with different strike prices and expiration dates to customize your investment strategy.
Disadvantages of Buying Calls
There are also some disadvantages to buying calls:
- Time decay: The value of a call option decreases over time as the expiration date approaches.
- Implied volatility: The premium you pay for a call option is affected by the implied volatility of the underlying security. Higher implied volatility means a higher premium.
- Early exercise risk: The seller of the call option may choose to exercise it early if the underlying security price rises significantly, which could limit your potential profits.
How Do Buy Calls Work? FAQs
Here are some frequently asked questions about how buy calls work:
- What is the difference between a call option and a put option?
A call option gives the buyer the right to buy the underlying security at a certain price, while a put option gives the buyer the right to sell the underlying security at a certain price
- What is the best way to choose a strike price?
The best strike price to choose depends on your investment goals and risk tolerance. If you are bullish on the underlying security, you may choose a strike price that is at or above the current market price. If you are more cautious, you may choose a strike price that is below the current market price.
- What is the best way to choose an expiration date?
The best expiration date to choose depends on your investment timeframe and how much time you think it will take for the underlying security to reach your target price.
- What is the best way to manage risk when buying calls?
There are several ways to manage risk when buying calls, such as using stop-loss orders and diversifying your portfolio.
- What are some tips for buying calls?
Here are some tips for buying calls:
* Do your research and understand the risks involved.* Choose strike prices and expiration dates that are appropriate for your investment goals.* Use stop-loss orders to limit your potential losses.* Diversify your portfolio by buying calls on different underlying securities.* Consider using covered calls to reduce your risk.Buying calls can be a profitable investment strategy, but it is important to understand the risks involved. By following the tips in this guide, you can increase your chances of success when buying calls.
Additional Resources:
- Investopedia: What Is a Call Option and How to Use It With Example
- Investopedia: A Beginner’s Guide to Call Buying
Keywords: buy calls, call options, options trading, investing, stock market, leverage, risk, profit, loss
Call-Buying Strategy
In order to purchase shares at the strike price on or before the expiration date, you must pay the option premium when you purchase a call. Because calls offer leverage, investors most frequently purchase them when they are optimistic about a stock or other security.
For example, assume ABC Co. trades for $50. A one-month at-the-money call option on the stock costs $3. Considering the following graphic illustration of the two different scenarios, which one would prefer to purchase: one call option for $300 ($3 × 100 shares) or 100 shares of ABC for $5,000? The payout of the call option is contingent upon the closing price of the stock one month from now.
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You can see that every investment has a different payoff. Although purchasing the stock will cost $5,000, you can purchase a call option for just $300 and own an equivalent number of shares. Furthermore take note of the fact that, when commissions and fees are excluded, the breakeven price for the stock trade is $50 per share, while the breakeven price for the option trade is $53 per share.
The potential loss scenarios for each investment are very different, even though they both have infinite upside potential in the month after purchase. As an illustration, consider this: If the share price drops to zero, the maximum loss on the option is $300, but the loss on the stock purchase could be the full $5,000 initial investment.
Closing the Position
Investors have two options for closing out their call positions: either they sell the calls back to the market or they exercise them, in which case they have to pay the counterparties who sold them the calls in cash (and get the shares in return).
To continue with our example, let’s say that the stock was trading at $55 close to the expiration date of one month. In these circumstances, you could sell your call for about $500 ($5 × 100 shares), netting you $200 ($500 minus the $300 premium).
As an alternative, you could have the call exercised, in which case the counterparty that sold you the call would deliver the shares after you paid $5,000 ($50 × 100 shares). The profit under this strategy would likewise be $200 ($5,500 – $5,000 – $300 = $200). Keep in mind that the $200 net profit from selling or exercising the call is the same.