What does it mean to “buy a call”? Call options are the right to control a stock at a certain price for a predetermined amount of time. Call options are quoted in price per share, but one option contract is for 100 shares of the underlying stock. The price of one contract is 100 times the quoted price.
A call option is a contract to buy a stock at an exact price within a specific time period. If a trader believes stock XYZ is going to increase in price, he can buy a call option for much less than the cost of the stock. He enjoys any increase in stock price as the option will increase in price as the stock goes up. If the stock price declines, the option can only decrease in price to $0.00 thus limiting the losses of the holder of the option to the purchase price of the option.
Let’s look at an example:
Present stock prices and amount committed:
XYZ stock priced at: $50.00 x 100 shares = $5,000.00
XYZ March $50 call: $ 3.00 x 100 = $ 300.00
Third Friday in March price:
XYZ stock priced at: $55.00 x 100 =$5,500.00
XYZ March $50 call: $ 5.00 x 100 =$ 500.00
In this instance, our trade made 10% on invested capital if we bought the stock, but made a 67% return on invested capital on the option contract. Now let’s look at the results if the stock did not perform as expected.
Present stock prices and amount committed:
XYZ stock priced at: $50.00 x 100 shares = $5,000.00
XYZ March $50 call: $ 3.00 x 100 = $ 300.00
Third Friday in March price:
XYZ stock priced at: $45.00 x 100 =$4,500.00
XYZ March $50 call: $ 5.00 x 100 =$ 0.00
In this example the XYZ stock lost $5 in price during the holding period. Our trade returned $4500 for a loss of $500, a 10% loss of capital. Our option expired worthless, but we only lost $300 on the trade rather than $500
This trade demonstrates three advantages of options:
1. If you are right in predicting the movement of the underlying stock, you will capitalize on most of the movement higher.
2. If you are wrong and the underlying stock moves against you, losses may be smaller than if you owned the stock itself.
3. Returns on invested capital can be much higher on option contracts with small moves in the underlying stock.
What is the largest disadvantage to options; time. You own a contract to purchase that is limited by time, and time decay can eat into your profits quickly. In the example above, our trader paid $3 ‘rent’ or time premium to control the underlying stock. If XYZ ended the time period at $52 dollars you would make back $2.00 for a loss of one dollar per share. It doesn’t matter if the stock goes to $55 per share a week after the option expires. You can be right in your prediction, but wrong in time frame and lose money. If you owned the stock outright, you could sell for the $52 per share and make a smaller profit or chose to wait longer for the higher target price.
Regular puts and calls may not be bought, or sold, in IRA or 401K accounts. The exception being covered calls. You must sign an option addendum with your online brokerage company to sell and buy options.
To buy a call option we enter the option symbol, it is generally made up of five letters. You may have to enter a (.) period in front of the symbol. Enter the quantity of contracts you want to purchase, remember each contract is for 100 shares. Option contracts trade with a Bid and Ask price, we highly recommend using limit orders on option contracts as the ‘spread’ is usually wider on options than on stocks. We use the ‘Buy to Open’ to place the order. This refers to ‘Opening’ the contract. If we chose to sell the option contract before it expires, we would ‘Sell to Close’ to close the contract.
We have talked about buying call option contracts; you can also sell call options. Using the XYZ company trading at $50, if we did not believe it would increase to $55 before the option expiration date, we could sell to open the $55 call for $3.00 per share. If it stays under $55 through option expiration day we get to keep the $3.00 premium. If XYZ goes over $55 per share we would have to buy the stock at the higher market price and sell it for $55 to the option owner, incurring a loss. This is not a trade you want to enter lightly, it can be dangerous. Thus it is called selling a “naked” call. The graphic description depicts you do not own the underlying security and can lose your shorts!
I hope this has been helpful to you. If you have experience in options, it may seem elementary, but remember the first option you bought. We all have to start somewhere. I encourage you to start by buying one contract, and monitoring your trade for experience. Experience is the very best teacher, and will help you understand the concepts better. There are wonderful resources available on options; we may write a more advanced article in the future.
John Dalt writes about the stock market daily for online investors. His MarketToday e-letter is sent to subscribers of galtstock. You can subscribe at http://www.galtstock.com
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