Options are contracts that give a buyer a right to purchase an underlying asset for a specific price by a certain date. Even though buying an option gives you the right to purchase the stock, you are not obligated to and can choose to let the option expire. Options trading is not the best option for new or casual traders unless they use a broker who is experienced in options. But if you think that making a foray into the world of options may be a good way to broaden your portfolio, then you will first need to understand what they are and how they work. Below is a guide that will help you understand:
- What a call option is.
- Examples of call options.
- How covered calls are used to generate income.
- How to use options for speculating.
- How to use options for tax management.
- How to strategize your call buying.
- How to close the position.
- What a put option is.
- What is an uncovered call.
What is a Call Option?
A call option is a type of financial contract that will provide the buyer with the right to purchase a commodity or asset for an agreed-upon price in a limited time-frame. If the buyer does not exercise these rights, then the option will expire. A buyer can profit from this transaction if the stock price increases above their agreed-upon purchase price.
When you enter into a call option contract, you are being offered the ability to buy up to 100 shares at a strike price that is set when the contract is made. To engage in the contract, the buyer will pay the seller a premium for the option. If the price does not rise above the stock price, you do not need to exercise the call and will simply be out the premium. But if the price of the shares is above the strike price, you can buy the stocks from the seller at the strike price and then sell them on the market for the higher price they are selling for.
Examples of Call Options
An example of a call option would be buying a single contract for 100 shares. You may be given a strike price of $150 and an expiration date of four months. The buyer of the option can choose to hold the option until the expiration date and then take delivery of the 100 shares, or they can choose to exercise the option before the expiration if the stock price rises and then sell it for a profit. The profit that you will make will be the value of the current market price minus the value of the strike price, plus the premium paid. So if the stock you bought is trading at $175 by the time that the option expires and the premium cost was $5, you would make $20 off of the contract. If you had multiple contracts, that number would go up times the number of contracts bought.
Covering Calls to Generate Income
There are some investors who will purchase call options as a way to generate additional income. This practice is called a covered call strategy. In this strategy, you will own the underlying stock and write a call option, which will give others the right to buy your stock. You would then collect the option premium with the hope that the buyer will let the option expire, and it becomes worthless, leaving you with the ability to gain the premium that you sold to the buyer of the option. This strategy can backfire if the stock price rises significantly. The writer will not profit off the movement of the stock and will only receive the premium.
Using Option Contracts for Speculating
Options can also be appealing for investors as it can provide them exposure to stock for a significantly lower price than it would be to buy the stock outright. When they pan out well, you can end up with a significant gain if the stock rises. But if it doesn’t that you will lose the total amount of your premium. The one benefit for speculators is that their risk exposure will be limited to the amount that you pay for the premium.
Some investors who use call options for speculation will buy and sell different options at the same time to create a call spread. By doing this, though, you will put a cap on the potential profits, but also can limit your potential losses.
Options for Tax Management
Options can also be used by investors so that they can alter their portfolio without having to buy or sell their securities. An example would be an investor who owns 200 shares of stock in ABC company who may be facing large unrealized capital gains. To prevent a taxable event, they can choose to use options to reduce the exposure of the security without actually having to sell it off. Even though gains from call and put options are also subject to taxation, the treatment is more complex, and in many cases, it will result in lower costs to the shareholders.
Strategizing Your Call Buying
Most investors will choose to buy calls when they see a bullish stock or other security. An example would be the stock of ABC company trading for $60. You can purchase a one-month call option for the low premium cost of $4. Your two options are to buy 100 shares of the stock outright for $6,000, or to buy a call option for $400. Both options may provide you with limited profits with only a month option, your potential for loss is extremely different. At worst, if you let the call option expire, then you would be out the $400 premium. If the stock were to plummet to zero, you could stand to lose $6,000.
How to Close the Position
You can choose to close your call position by exercising the option of selling them back on the market. If you choose to exercise if, then you must pay the party that sold them. Using the example above, if the stock was trading at $65 close to the end of the month expiration, you could sell the call for $500. This would net you a profit of $100.
If you decide to exercise the call, you will pay the value of the share at the strike price of $60 per share or $6,000 to the person who sold the stock. If you then turn around and sell the stock on the open market, you would make $500 less the $400 premium you paid, netting the same profit of $100.
What is a Put Option?
When you decide to buy a put option, you are purchasing the right to force the seller of the put to buy 100 shares of stock from you at the strike price decided on in the contract. What you are looking for when you buy a put option, if for the price of the stock to drop below the strike price. So you are, in fact, betting on the stock to lose. Since you will have the ability to force the seller of the option to purchase your shares for the now above market price, your put option will act as a form of an insurance policy to protect you against a drop in the stock’s value.
In the event that the prices increase instead of drops, it will be in your best interest to allow the option to expire, in which case you will only be out the amount of the premium that you paid to purchase the put. Put options are used by investors as a way to hedge against potential losses and are often used more conservatively because of this.
What is an Uncovered Call?
There are also riskier options strategy that seems more like gambling as they can open you up to a significant amount of risk than more traditional options trading. One of these more risky strategies is called uncovered calls. When a call is exercised, then the seller must deliver the stock. When you decide to sell a call on the stock that your own, it is called a covered call because you already own the stock and have incurred the cost of purchasing it. If the buyer exercises the option, you simply have to deliver the stock you own, as promised.
An uncovered call means you are selling a call on a stock that you do not own. This means if the call is exercised, you will be responsible for buying the stock on the open market to cover your portion of the contract. If the stock price is significantly higher than the strike price, you can be subject to heavy losses. This can be a substantial hit if the market is strong or a recent announcement has caused the stock to skyrocket.
Trading calls is a great way to allow yourself more exposure to different stocks and securities, without putting up a lot of funds in advanced. These types of calls are popular trading strategies for many larges investors and investing funds. If you are looking to get started in options trading and would like to learn more about how to be successful, download our free e-book, or attend one of our online webinars.