The world of stock option trading is founded on two basic building blocks: calls and puts. The first step of every option trader’s journey lies in learning how exactly both of these trading vehicles work. Today’s article will focus on the simpler of the two – call options.
Most traders who buy call options do so with the intent of selling them later at a higher price. The concept of buying low and selling high is a shared objective among stock and option traders alike. If I buy a call option for $3 then I’m hoping to sell it later for $4, $5 or, hopefully, much more.
A call option gives the buyer of the contract the right, but not the obligation, to buy 100 shares of stock at a specific price on or before an expiration date.
This right to buy the stock at a set price becomes more valuable as the stock price rises further and further. For example, if Apple Inc. (NASDAQ:AAPL) is trading for $150 and I buy a six month call option granting me the right to buy 100 shares of AAPL at $150 , then my call option would become increasingly valuable if AAPL stock were to rally to $160, $170, and beyond. This is why buying a call option is considered a bullish trade.
Think of it as an alternative to buying stock. And what makes it particularly attractive (as mentioned in What are Stock Options? A Path to Huge Profits, That’s What) is that it’s a cheaper, more leveraged alternative to buying stock.
Perhaps the best way to wrap your ahead around the embedded advantages to buying call options is to see a side by side comparison versus buying stock. Suppose you’re looking to initiate a bullish position on Walt Disney Co (NYSE:DIS), which recently traded near $115.
Long Stock
If you take the stock route by snatching up 100 shares, your cost would be $11,500. Even if your broker gives you 2-to-1 margin, you’ll still have to tie up half that amount, or $5,750. Regardless of the initial capital required, the max theoretical risk is $11,500. On the positive side the potential profit is unlimited.
Long Call Options
As an alternative to buying 100 shares of Disney stock, I could buy a six-month $115 call option for $660. The call option locks in the right to buy 100 shares of DIS at $115 for the next six months. But, instead of having to shell out $11,500 (or $5,750) in capital, and taking as much in risk, my cost is limited to a mere $660. Plus, I still have unlimited profit potential over the next six months should Disney stock rocket higher.
And here’s the kicker. If Disney moves favorably, the call option will generate a much higher percentage return than a simple long stock position would. It’s not uncommon for a 5% pop in the stock to deliver a 50% profit (or higher) to call option owners.
Be aware, however, that leverage slices both ways. Yes, the profits rack up fast, but so too can the losses. So don’t forget to consider risk management before diving head first into the option pool.
Call options are particularly attractive on expensive stocks that have otherwise priced out the little guy. If you’ve shied away from big wigs of the Street like Priceline Group Inc (NASDAQ:PCLN), which trades for four digits, call options (and option trades in general) may be just the admission ticket you need.
The uses of long call options are myriad. In addition to the using calls in lieu of buying stock, you could also use them to solve the fortunate dilemma of when to take profits on a winning stock position. Say I bought 100 Disney shares at $100 in December. When the stock was perched at $115, I was sitting on a nice $1,500 profit.
If I was bullish, I would’ve had to make a choice between staying in (which, good thing I did) or staying out and risk Disney going long without me. The compromise would’ve been swapping out 100 shares of DIS for a long call option, where much less was lost on the decline.
Do yourself a favor and continue exploring how to effectively use call options to reduce risk while enhancing your investment returns.
