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Call Options

Call Option: the right to buy the underlying at the strike price until expiration

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 CALL OPTION

A call option is a contract between two parties that provides the buyer a right and the seller an obligation. The person who buys (goes long) a call option has purchased the right to buy the underlying security at an agreed upon price. The person who sells (writes) a call has an obligation to produce and sell the underlying investment at an agreed upon price. One option contract is equal to 100 shares of the underlying stock. An option consists of three characteristics:

Strike price – the price at which the buyer can take possession and the seller is obligated to deliver.

Premium – the amount of money paid by the buyer and collected by the seller

Expiration date – This is the date the option becomes worthless if the buyer isn’t in the money or doesn’t exercise his/her right.

An option incorporates a time value in the price. For example, lets say XYZ is trading at 50 and the 50 call strike premium is 3$ with 4 weeks left before expiration. If XYZ doesn’t fluctuate, staying constant at 50, the price of the 50 call premium will gradually reduce from 3$ to zero as the 4 week time line decays ultimately ending with a value of zero on expiration day.

As you can imagine, given the worlds stock, currency, futures and commodity markets, there are almost unlimited investments most of which have some sort of tradeable option. There are American and European style options. American style options can be exercised at any point up to expiration whereas the European can only be exercised on the date of expiration. On many investable instruments options trade weekly, monthly, quarterly and yearly. Option expiration dates typically fall on a Friday with the most common expiration date being the third Friday of the month. There are exceptions however. For example, options on the S&P 500 volatility index (VIX) expire on the 3rd Wednesday of the month and quarterly options expire on the last day of the quarter.

 

GOING LONG

Buying, or going long, a call is a a way to gain exposure to an upside move in an underlying investment with a known capped amount of risk. Lets say XYZ is trading at 100 and you think XYZ is going to trade up to 110 before the next options expiration date. In our example you can buy the next month’s XYZ 110 call for 2$. Your risk is 2$ regardless of the direction of XYZ over the next month. If XYZ close at 112 on expiration day you have a 10$ gain. You profit inline with the stock dollar for dollar minus the 2$ premium.


You can also go long call options to utilize more, lower risk, exposure to an investment than you could otherwise afford. For example, lets say our XYZ is trading at 100 and you want exposure to 100 shares. Buying the shares outright would cost 10,000.00$ but with our above example you can own one call (exposure to 100 shares) for 200$. You have risk 200$ to benefit with a potential upward move in 10k worth of stock.

 

GOT YOU COVERED

Got You Covered refers to selling covered calls. In most qualified accounts, covered calls and covered call spreads are the only option trades that can be executed. Covered calls can be used in a variety of ways which can include generating income, allowing for possible upside appreciation and provide an investor with downside protection. In addition to active traders, these strategies can prove very useful to retirees who have equity positions and want to supplement retirement income. Covered calls can also be beneficial to investors who have equity positions and want to reinvest the income generated to increase compounding. Below are a few hypothetical examples of how a covered call strategy, when utilized, can be a useful tool.

 

GENERATE INCOME

Buy (go long) 1000 shares of XYZ stock at 100 on October 1st (sell) the November 100 call for $3 generating $3000.00. By accepting the  $3 premium you have agreed to sell your XYZ stock at 100 anytime between the day you sold the call and expiration of the month the call was sold out to, in this example November. The person who is long (bought the call) can exercise his call and your XYZ stock will be called away. Assume XYZ stock closes at 110 on November expiration, by owning XYZ stock the trade is covered which means you don’t have to go out in the open market and buy the stock at 110 and then sell the stock at 100 if it is called away, which would be very costly. By buying XYZ stock at 100 and selling the ON THE MONEY 100 call, you generate the highest possible amount of income but have no downside protection and no chance for upside appreciation. If stock is called away at 100: 100 + 3 = 103

GENERATE INCOME WITH POSSIBLE APPRECIATION

Buy (go long) 1000 shares of company XYZ at 100 on October 1st write (sell) the OUT OF THE MONEY November 105 call for $1.00 generating $1000.00. By writing the call and receiving the $1 premium you have now agreed to sell your XYZ stock at 105 anytime between the day you wrote the call through expiration of the month the call goes out to, in this example the third Friday of November. By being long, the XYZ stock your call is covered, which means if XYZ stock closes at 110 on expiration you don’t have to go out in the open market, buy the XYZ at 110 then sell it at 105 when it’s called away. This would be very costly. In this example you have no downside protection but would realize any appreciation between 100 and 105 as well as the $1 premium for selling the call. You may choose to leave the $1000.00 in your account, which would essentially reduce your cost basis to 99, or withdraw the $1000.00, which can then be used as income.  If stock is called away at 105: 100 + 5 + 1 = 106

GENERATE INCOME WITH DOWNSIDE PROTECTION

Similar to the above examples. On October 1st stock at 100 and sell (write) the IN THE MONEY November 95 call for $6 generating $6000.00. By accepting the $6 premium, you have agreed to sell your XYZ stock at 95 anytime between when you sold the call and expiration in November. By being long XYZ stock, you are covered if a person who is long the 95 call chooses to exercise, thus calling your stock away at 95. In this example, you receive the $1000.00 difference between 100 where you bought XYZ, 95 where you sold XYZ and the $6 you received when you wrote the call. You have no chance for upside appreciation here, but you have $5 downside protection. You haven’t lost money unless XYZ drops below 94. Unlike selling OUT OF THE MONEY calls, this more conservative strategy is a great way to generate income while providing some protection against declines. If stock is called away at 95: 100 – 95 + 6 = 101