Beginner’s Guide to Call Buying

The popular misconception that 90% of all options expire worthless frightens investors into mistakenly believing that if they buy options, they’ll lose money 90% of the time. But in actuality, the Chicago Board Options Exchange (CBOE) estimates that only about 30% of options expire worthless, while 10% are exercised, and the remaining 60% are traded out or closed by creating an offsetting position.

Call Buying Strategy

When you buy a call, you pay the option premium in exchange for the right to buy shares at a fixed price (strike price) on or before a certain date (expiration date). Investors most often buy calls when they are bullish on a stock or other security because it offers leverage.

For example, assume ABC Co. trades for $50. A one-month at-the-money call option on the stock costs $3. Would you rather buy 100 shares of ABC for $5,000 or would you rather buy one call option for $300 ($3 x 100 shares), with the payoff being dependent 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 payoff for each investment is different. While buying the stock will require an investment of $5,000, you can control an equal number of shares for just $300 by buying a call option. Also note that the breakeven price on the stock trade is $50 per share, while the breakeven price on the option trade is $53 per share (not factoring in commissions or fees).

While both investments have unlimited upside potential in the month following their purchase, the potential loss scenarios are vastly different. Case in point: While the biggest potential loss on the option is $300, the loss on the stock purchase can be the entire $5,000 initial investment, should the share price plummet to zero.

Closing the Position

Investors may close out their call positions by selling them back to the market or by having them exercised, in which case they must deliver cash to the counterparties who sold them the calls (and receive the shares in exchange).

Continuing with our example, let’s assume that the stock was trading at $55 near the one-month expiration. Under this set of circumstances, you could sell your call for approximately $500 ($5 x 100 shares), which would give you a net profit of $200 ($500 minus the $300 premium).

Alternatively, you could have the call exercised, in which case you would be compelled to pay $5,000 ($50 x 100 shares) and the counterparty who sold you the call would deliver the shares. With this approach, the profit would also be $200 ($5,500 – $5,000 – $300 = $200). Note that the payoff from exercising or selling the call is an identical net profit of $200.

Call Option Considerations

Buying calls entails more decisions compared with buying the underlying stock. Assuming that you have decided on the stock on which to buy calls, here are some factors that need to be taken into consideration –

• 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, at the current ABC Co. stock price of $50, you would only be able to buy 30 shares. But based on the one-month call price of $3, you would be able to buy 5 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 trade-off between time and cost. Option contracts typically expire on the third Friday of each month.
• Number of option contracts: Once the strike price and 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 5 contracts for the full amount you have available to invest, or buy 3 or 4 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 limit order for your calls.

The Bottom Line

Trading calls can be an effective way of increasing exposure to stocks or other securities, without tying up a lot of funds. Such calls are used extensively by funds and large investors, allowing both to control large amounts of shares with relatively little capital.