How Does Buying Call Options Work?

by OTC Financial | Last Updated: 4 months ago
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When the price of a stock rises, the value of a call option rises as well.

They’re the most well-known choice, and they allow the owner to lock in a price to purchase a specific stock by a certain date.

The appeal of call options is that they might appreciate swiftly in response to a slight increase in the stock price.

As a result, they’re a favorite among traders aiming for a big profit.

What Is A Call Option?

A call option is a contract that offers an investor the right to acquire a specific number of shares or other assets at a specific price for a specific time period.

This is a risky technique of betting that the value of an asset will rise or fall as you predict – and that it will do so rapidly.

Call options give you the power to profit from the running price of the underlying stock at a very small cost and without having to buy the underlying stock first.

So, for example, if you buy a call option and the stock’s value rises over the option’s “strike price” before the option expires, you can exercise the option and profit.

You’ll lose your entire investment if you don’t.

Call options can be utilized for a variety of purposes other than betting on rising stock prices, such as limiting possible losses and profiting from market merger and acquisition activity.

I just want to clarify about strike price; it is the price at which an option can be converted into shares of stock if it is exercised (which means the option buyer converts the option into shares of stock)

A contract is an option that represents 100 shares of the underlying stock.

Options pricing is quoted on exchanges in terms of per-share costs, not the overall cost of ownership.

For example, on the exchange, an option might be quoted at $0.95. So it will cost $95 to buy one contract (100 shares * 1 contract * $0.95).

Small retail investors take advantage of call options as a speculative instrument to get big profits with very little capital.

Not only do small investors take advantage of this call option, but investors from large institutions also use it to protect their stock portfolios and increase marginal profit.

How Do Call Options Work?

A call option is a financial contract that is entered into between a buyer and a seller.

Whereby the “Writer” or the seller gives the call option buyer the right to buy his shares at a fixed rate that has been agreed upon in the call option contract.

“Holders” or buyers can now use it, hoping that the stock will rise in price from time to time before the contract expires.

Then sell the call option to another buyer at a higher price or exercise the right in the call option to buy shares from the seller at an agreed lower price, then get a profit from selling these shares on the open market.

The following are examples of transactions that occur in call options::

 Company ABCD stock is trading at $40 currently. The $40 strike price Call Options trade at $2.

  • John bought 100 shares of company ABCD for $30 a week ago and expects shares of company ABCD to rise slightly after a strong run. He decided to support his ABCD stock position by selling 1 contract (representing 100 shares) of Call Options’ strike price for $40. He earned $200 from the sale of Call Options, which would recoup his losses if company ABCD’s stock fell by less than $2 and increase his profit if company ABCD’s stock remained stagnant at $40 when the Call Options expired.
  • Peter expects that company ABCD shares will continue to run strong. He wanted to take advantage of it and didn’t want to pay $40 per share. He decides to buy the $40 strike price Call Options for just $200 ($2 x 100), controlling 100 shares. To control 100 shares, he usually has to pay $4000 ($40 x 100) to own the shares, but with Call options, he does so for only $200, which is only 5% of the usual price!

So, at this time, two scenarios can occur when making a call option transaction:

–         Scenario 1: ABCD up to $70 During Call Options Expiration

ABC John’s stock was reclaimed by the buyer of his Call Options for $40. He made a total profit of $40 – $30 + $2 = $12 from this trade.

Peter’s $40 strike price for Call Options is now $30 because it allowed him to buy XYZ stock for $40 when trading at $70 today.

He made a total profit of $30 – $2 (Call Options price) = $28 per contract or 1400% profit!

–         Scenario 2: ABCD Drops To $38 During Call Options Expiration

ABC Jack’s stock lost $2 per share, which was entirely offset by the sale of Call Options for $2 per share. John had nothing to lose in this trade.

Peter’s ABC stock matures with no value because there is no value in the right to buy ABC stock for $40 when it trades at $38 today. Peter lost the $200 he used to buy the Call Options.

Buying Call Options VS Buying Common Stock

You may be wondering why someone buys an options contract instead of owning directly every share of a company.

Well, of course, the answer is because buying call options is much more profitable than buying shares in the spot market.

But, to get that big profit, you also need extra analysis of price movements in the market. You need to know whether the stock will go up soon or even down.

Because if it’s not like that, then it’s not the benefit you will get.

But the loss is quite significant too. Remember, back to the basic investment law: high-risk, high return.

If you are a retailer with unused money, then instead of buying shares on the spot market, it’s a good idea to try the options market.

Of course, before that, you have to make sure the knowledge and skills you have are sufficient to make a call option.

You certainly don’t want the capital you have to just disappear due to your carelessness.

Let’s take an example; suppose you make a call option on stock ABC which is currently trading at $100 per share.

A call option with a strike price of $100 is charged at the cost of $10 and expires in five months.

Because each contract represents one hundred shares of stock, the cost of one contract is $1000.

Say you have 1000 dollars as your capital; that means you can buy 1 contract or 10 shares of stock for $100

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You can see from the calculation above that call options provide very attractive benefits compared to buying shares of common stock in the spot market.

A shareholder receives only $400 of profit on a 40% increase ( $140(market price) – $100 (purchase price) = $40 (gain per share) X 10 shares = $400 )

But if you buy a call option then after a significant increase of 40% you have received a profit of $3000 ( $140(market price) – $100 (purchase price) = $40 (gain per share) – 10 Cost = $30 x 1 Contract (100 shares ) = $3000)

That’s a great advantage. The advantages of buying call options compared to buying shares in the spot market.

In the spot market, the losses you receive are getting bigger in how far the market has dropped from the purchase price.

However, if the market experiences a significant decline in call options, no matter how deep the decline is, your loss is only limited to the capital you risked during the transaction.

Still, if the price rises even too far above the strike price, your profits will be unlimited.

Terminology Of The Call Option

●       Strike Price

It is the price at which you as a trader buy shares of a company and make that price the benchmark.

So it doesn’t matter if the price moves up or down; you already own stock at that price.

●       Holder

Those who have call options. If you buy a call option, you are a holder (buyer) of the call option.

●       Exercise Price

The price at which an option offers the right to buy or sell a stock, commodity, or currency is known as the exercise price.

Only if this price is better for the holding party than the marker price will the option be exercised.

If the exercise price exceeds the market price, the put option will be used to sell the asset, and the call option will be used to acquire the asset if the exercise price is lower.

●       Expiration Date

Each option contract, unlike a stock, has a predetermined expiration date.

Because the time you have to buy, sell, or exercise the option contract is limited, the expiration date substantially impacts its value.

When an options contract’s expiration date arrives, it will either be exercised or become worthless.

●       In The Money

In the money, an option has value because of the relationship between the option’s exercise price (strike price) and the current market price for the underlying instrument (spot price).

A call option is in the money when the strike price is below the spot price.

A put option is in the money when the strike price is above the spot price.

●       At The Money

At the money is mean options have a strike price equal to the current market price of the underlying stock.

At-the-money options have no intrinsic value, but they may be profitable before expiration because they have a temporal value.

●       Out of The Money

Out-of-the-money (OTM) is used to describe option contracts with only extrinsic value.

Which Option Strategy Is Most Profitable?

If we talk about an investment or trading system, it cannot be separated from the discussion about investment/trading strategies.

Which is the best strategy? Which is more profitable? Which is the most successful strategy?

Yes, that question is a question that is always asked by traders, especially traders who have just tried options trading.

So here are some strategies you can use when you buy call options :

●       Fiduciary Calls

Protective put options are being phased out in favor of fiduciary call options (also known as married put options).

Call options are more expensive with low cost and low capital input and need a substantial upfront commitment.

●       Bull Call Spread

Holding short-term call options to cover the expenses of long-term call options allows you to profit from mild increases in the underlying stock.

●       Calendar Call Spread

A calendar spread is an option or futures trading method in which two positions are opened simultaneously, one long and one short.

●       Naked Call Write

When you sell to open call options without first owning the underlying stock, this is known as a naked call write.

You’re selling the right to buy the underlying stock at a specific price without owning it.

●       Stock Replacement Strategy

It’s an options strategy that can be basic or sophisticated, and it’s flexible enough to meet the needs of novice and experienced options traders.

The Stock Replacement Strategy’s primary goal is to reduce overall portfolio risk by replacing equities with deep in the money call options and then using the remaining capital for smart hedging as the trade unfolds.

You can apply some call option strategies in your trading plan.

Remember to constantly upgrade your skills and strategy on a demo account before jumping into a real account.

Look for a strategy that fits your trading style and is the most profitable for you because everyone is different in determining their strategy when making call options.

Call Options Advantages And Disadvantages

Advantages

  • It could be used as a hedge against stock or option positions.
  • With “capped risk,” you have unrestricted protection of profit possibilities.

Disadvantages

  • If the shares trade below the strike price until maturity, there will be no value.

Final Thoughts

Call options are derivatives of an underlying security that can provide investors with various strategies across a wide range of equities.

Leveraging one’s exposure to higher price moves in specific equities or commodities is a key use case for call option buyers.

At the same time, other investors will benefit from the extra revenue generated by selling covered out-of-the-money calls on occasion.

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