If you are bullish about a stock, buying calls versus buying the stock lets you control the same amount of shares with less money. If the stock does rise, your percentage gains may be much higher than if you simply bought and sold the stock.
Of course, there are unique risks associated with trading options. Read on to see whether buying calls may be an appropriate strategy for you.
The basics of call options
The buyer of call options has the right, but not the obligation, to buy an underlying security at a specified strike price. That may seem like a lot of stock market jargon, but all it means is that if you were to buy call options on XYZ stock, for example, you would have the right to buy XYZ stock at an agreed-upon price before a specific date.
The primary reason you might choose to buy a call option, as opposed to simply buying a stock, is that options enable you to control the same amount of stock with less money.
For instance, if you had $5,000, you could buy 100 shares of a stock trading at $50 per share (excluding trading costs), or you could purchase call options that grant you the right to buy the same amount of shares for significantly less, as we’ll demonstrate shortly.
The characteristics of call options
Compared with buying stock, buying call options requires a little more work. Knowing how options work is crucial to understanding whether buying calls is an appropriate strategy for you. There are several decisions that must be made before buying options. These include:
- The security on which to buy call options. Suppose you think XYZ Company stock is going to rise over a specific period of time. You might consider buying XYZ call options.
- The trade amount that can be supported. This is the maximum amount of money you would like to use to buy call options.
- The number of options contracts to buy. Each options contract controls 100 shares of the underlying stock. Buying three call options contracts, for example, grants the owner the right, but not the obligation, to buy 300 shares (3 x 100 = 300).
- The strike price. This is the price at which the owner of options can buy the underlying security when the option is exercised. For instance, XYZ 50 call options grants the owner the right to buy XYZ stock at $50, regardless of what the current market price is. In this case, $50 is the strike price (this is also known as the exercise price).
- The price to pay for the options. Whereas you buy the stock for the stock price, options are bought for what’s known as the premium. This is the price that it costs to buy options. Using our 50 XYZ call options example, the premium might be $3 per contract. So, the total cost of buying one XYZ 50 call option contract would be $300 ($3 premium per contract x 100 shares that the options control x 1 total contract = $300). If the premium were $4 per contract, instead of $3, the total cost of buying three contracts would be $1,200 ($4 per contract x 100 shares that the options control x 3 total contracts = $1,200).
- The expiration month. Options do not last indefinitely; they have an expiration date. If the stock closes below the strike price and a call option has not been exercised by the expiration date, it expires worthless and the buyer no longer has the right to buy the underlying asset and the buyer loses the premium he or she paid for the option. Most stocks have options contracts that last up to nine months. Traditional options contracts typically expire on the third Friday of each month.
- The type of order. Like stocks, options prices are constantly changing. Consequently, you can choose the type of trading order with which to purchase an options contract. There are several types of orders, including market, limit, stop-loss, stop-limit, trailing-stop-loss, and trailing-stop-limit.
Options enable leverage
There’s an important point to note about the price you pay for options. Notice how buying one contract would cost $300, and this would grant the owner of the call options the right (but not the obligation) to buy 100 shares of XYZ Company at $50 a share.
Now, compare that with the cost of buying the stock, rather than buying the call options. To purchase 100 shares of XYZ Company, you would need to pay $5,000 ($50 per share x 100 shares). This illustrates the primary purpose of options. They effectively allow you to control more shares at a fraction of the price. That’s leverage at work.
Of course, once you exercise the options, you have to pay for the stock at the strike price—$50 in this case. But you would do so only if the stock price had risen high enough for the option to be in the money—a term that implies an option is worth exercising because the stock price is above the option’s strike price. The ultimate goal is for the stock price to rise high enough so that it is in the money and it covers the cost of purchasing the options.
Advantages and disadvantages
In addition to being able to control the same amount of shares with less money, a benefit of buying a call option versus purchasing 100 shares is that the maximum loss is lower. Plus, you know the maximum risk of the trade at the outset.
The maximum risk of buying $5,000 worth of shares is theoretically the entire $5,000, because, while it is unlikely, the stock could go to zero. In our example, the maximum risk of buying one call options contract (which grants you the right to control 100 shares) is $300. The risk of buying the call options in our example, as opposed to simply buying the stock, is that you could lose the $300 you paid for the call options.
If the stock decreased in value and you were not able to exercise the call options to buy the stock, you would obviously not own the shares as you wanted to. Alternatively, if you simply bought the stock at $50 per share, you would own it right away, rather than having to wait on exercising the call options to potentially own the shares.
Another disadvantage of buying options is that they lose value over time because there is an expiration date. Stocks do not have an expiration date. Also, the owner of a stock receives dividends, whereas the owners of call options do not receive dividends.
Before making any trade, it’s extremely helpful to know the maximum potential profit or loss you can incur. This is particularly true for options trades.
The maximum potential profit for buying calls is the same profit potential as buying stock: it is theoretically unlimited. The reason is that a stock can rise indefinitely, and so, too, can the value of an option.
Conversely, the maximum potential loss is the premium paid to purchase the call options. If the underlying stock declines below the strike price at expiration, purchased call options expire worthless. Recalling our previous example, the maximum potential loss for buying one call options contract with a $3 premium is $300. If the stock does not rise above the strike price before the expiration date, your purchased options expire worthless and the trade is over.
How you make an options trade
You must first qualify to trade options with your brokerage account. At Fidelity, this requires completing an options application which asks questions about your financial situation and investing experience, and reading and signing an options agreement. Assuming you have signed an options trading agreement, the process of buying options is similar to buying stock, with a few differences.
You would begin by accessing your brokerage account and selecting a stock for which you want to trade options. Once you have selected a stock, you would go to the options chain. An options chain is where all options contracts are listed.
After you’ve selected the specific options contract that you’d like to trade, an options trade ticket is opened and you would enter a buy to open order to buy call options. Then you would make the appropriate selections (type of option, order type, number of options, and expiration month) to place the order.