Congratulations: you've graduated from Stock Investing University! You now have a firm grasp on buying and selling stocks. But you've heard there’s more to investing than just buying low and selling high—it may be time to consider investing with options. Unlike stocks, options allow you to gain exposure to a stock, whether it's on the rise, fall, or even moving sideways. Like a Swiss Army knife, options give you the versatility to persevere during the tough times and prosper during the good times.
Why use options?
Options are more advanced tools that can help investors limit risk, increase income, and plan ahead.
What are call options?
A call option is a contract between a buyer and a seller to purchase a certain stock at a certain price up until a defined expiration date. The buyer of a call has the right, not the obligation, to exercise the call and purchase the stocks. On the other hand, the seller of the call has the obligation and not the right to deliver the stock if assigned by the buyer.
For instance, 1 ABC 110 call option gives the owner the right to buy 100 ABC Inc. shares for $110 each (that's the strike price), regardless of the market price of ABC shares, until the option's expiration date.
Suppose ABC shares are trading at $100 today—the owner of the ABC 110 call option hopes shares rise above $110—any appreciation above that represents the potential payout. If you exercise the call when shares trade at $120, then you buy 100 ABC shares for $110 and voilà: your return is $10 per share for a total gain of $1,000.
But all that fun isn't free. A call buyer must pay the seller a premium: for example, a price of $3 per share. Since the ABC 110 call option then cost $300 and paid out $1,000, the net return is $700.
Note that these examples do not include any commissions or fees that may be incurred, as well as tax implications.
A long call: speculation or planning ahead
A "long call" is a purchased call option with an open right to buy shares. The buyer with the "long call position" paid for the right to buy shares in the underlying stock at the strike price and costs a fraction of the underlying stock price and has upside potential value (if the stock price of the underlying stock increases).
A long call can be used for speculation. For example, companies have product launches that occur around the same time every year. You could speculate by purchasing a call if you think the stock price will appreciate after the launch.
A long call can also help you plan ahead. For example, you may have an upcoming bonus that you would like to invest in a stock today, but what if it didn't pay out until the following month? To plan ahead and lock in the price of the stock today, you could purchase a long call with the intent to exercise your right to purchase the shares once you receive your bonus.
A short call: boosting income
A "short call" is the open obligation to sell shares. The seller of a call with the "short call position" received payment for the call but is obligated to sell shares of the underlying stock at the strike price of the call until the expiration date. A short call is used to create income: the investor earns the premium but has upside risk (if the underlying stock price rises above the strike price).
Both new and seasoned investors will use short calls to boost their income, but more often than not do so when the call is "covered." So in case you are assigned, you are simply selling stock which you already own.
An "uncovered" call carries significantly more risk and a potential for unlimited losses because you are obligated to find shares to sell to the call purchaser. Imagine if you had to buy shares which were 20% more expensive than the price you are selling them for. Yikes!
Exercise of a call
A long call investor hopes the price of the underlying stock rises above the exercise price, only then could it make sense to exercise a call. Why would you exercise your right to buy ABC shares for $110 each when anybody can buy them on the market for less than that?
"Exercising a long call" means the call option owner is demanding to buy the stock from the call seller. Upon exercise of a call, shares are deposited into your account and cash to pay for the shares and commission is withdrawn (just like a normal stock purchase).
It's important to note that exercising is not the only way to turn an option trade profitable. For options that are "in-the-money," most investors will sell their option contracts in the market to someone else prior to expiration to collect their profits.
Assignment of a short call
A short call investor hopes the price of the underlying stock does not rise above the strike price. If it does, the long call investor may exercise the call and create an "assignment." Assignment can occur on any business day before the expiration date. If it does, the short call investor must sell shares at the exercise price.
Remember from earlier: the call is "covered" if you sell shares you already own, but if it's "uncovered" you must find shares to sell to call purchaser.
Next steps to consider
It's easy—opening your new account takes just minutes.
We'll explain the process, what to expect and provide answers to frequently asked questions.
Learn more about the resources and a few tips to help you find option candidates and strategies.