Options are a sophisticated strategy that enables investors to reduce risk and improve revenue. But most importantly make plans in advance.
The concept of a call option is a form of an agreement that empowers traders to purchase bonds, stocks, and other securities at a predetermined price up to a fixed date of expiration.
It’s crucial to discern that as financial contracts, call options allow traders to buy a specific asset, but there is no obligation to purchase at a particular price within a given time period.
The underlying asset can be any type of bond, stock, or commodity. And the call buyer earns money if the traded asset’s price rises.
The alternative to the call option is the put option, where the investor that possesses a certain asset, has the right to sell the stock or bond at a particular price before the expiration.
Let’s examine call options in more detail and learn how to implement them in the stock market.
Also Read: Day Trading Options: A Risky Yet Profitable Strategy
Contents
- Understanding Call Options
- Important Factors for Selling a Call Option
- Types of Call Options
- Implementing Options for Income
- Implementing Options for Speculation
- Options for Tax Management
- Best Time to Sell a Call Option
- Are Call Options Bullish or Bearish?
- Conclusion
- FAQs
Understanding Call Options
We can illustrate call options with a hypothetical example of stock from some tech company we will call X Computers. As we already said, call options, enable an investor to buy the underlining asset. In our case to purchase 50 shares of X Computers at a particular price, that gets referred to as the strike price, up until a given date, called the expiration date.
A single call option contract enables the investor to buy 100 shares of X Computers at $200, up until the expiration date six months later. Traders can select from several dates of expiration and strike prices.
If the worth of X Computers starts rising, it will influence the option contract’s price which is going to follow the trajectory of the stock it’s attached to.
The trader that holds the call option can retain the contract until the date of expiration. When that date arrives, they can assume possession of the 100 shares of stock, or they can choose to sell the options contract before the expiration date, but in that case, they will receive the current market price for the contract.
When purchasing a call option, investors must pay a premium, which is a sort of fee. This is the cost to acquire the rights that are intrinsic to the call option. When during the expiration date the asset is under the strike price, the buyer of the call option buyer forfeits the paid premium paid. It’s a maximum loss.
But when the asset’s present market price is over the strike price at expiration, the difference in prices, minus the premium is the profit. This amount gets multiplied by the number of shares under the control of the option’s buyer.
For example, if X Computers get traded at $200 at expiry, and the strike price of the option is $195, and the options cost the buyer $1 per share. In this case, the profit is $200 minus the total of $195 plus $1, which equals $4. If the buyer purchases a single options contract, the profit equates to $400 because $4 multiplied by 100 shares is the stated number.
But if at expiration X Computers gets traded under $195, in that case, the trader will not use the right to acquire the option, and the contract expires worthless. The trader will lose $1 per share, or $100, for each contract they purchased. This is the advantage of options, investors can lose only the premium if they decline to accept the contract.
Important Factors for Selling a Call Option
Making a profit is a possibility by selling a call option when the assets price is trading under the strike price. Yet, it’s crucial to consider the following factors before making a decision:
- Number of Contracts: Every options contract contains 100 shares. The premium is higher if a trader manages to sell a larger quantity of contracts. Yet to do this, they must possess more shares from the given stock.
- Premium: This is the upfront cost for selling a call option. The premium hinges on the difference between the spot price and the strike price. It will decline if the strike price increases and separates from the spot price. However, a call with a smaller premium has a reduced chance of being assigned.
- Strike Price: This is the price at which the holder of the asset is compelled to sell the underlying asset if a call gets assigned. Calls that have a larger strike price, have a reduced chance of being assigned and because of this produce a lower premium. In response contracts with a lower strike price have more chance to move in-the-money position. This makes it possible to be assigned. When all factors are stable, investors should aim for a call option with a larger strike price, and the reason is the increased leeway to profit from the rise of a particular stock’s price.
- Expiration Date:The premium accepted by the seller of a call option rises as the expiration date nears. The paramount argument is basic as the expiration date closes, the particular stock’s potential to go into an in-the-money position improves. When this occurs, the covered call option will get assigned. To balance the risk, the premium will rise.
Types of Call Options
Call options come in two types, and it’s time to explore both formats.
Short call option
The name reveals that the seller pledges to sell the shares at a locked future price. Short call options are generally implemented for covered calls or call options where the seller possesses the specific asset for their options. The call enables to restrain losses if the trade does not go as planned. The losses can increase if the call gets uncovered and the asset drastically increases in price.
Long call option
The benefit of a long call permits investors to strategies ahead and buy a stock at a smaller price. For example, traders can buy a long call option in advance of a significant event, such as an earnings report of a company. Although the potential earnings of a long call option can be unlimited, the losses get restricted to the premiums. Because of this if the anticipated reports don’t materialize, and the share price decline, then losses get limited to the paid premiums for the option.
Implementing Options for Income
Some traders use call options as a source of income by implementing a covered call strategy. The concept is based on taking possession of a specific stock and simultaneously writing a call option. It’s also possible to allow another trader the privilege to purchase your stock.
The investor gets the premium of the option and desires the option to expire under the strike price in other words the option expires worthless. This strategy produces extra income for the trader, but it doesn’t guarantee profits if the price of the underlying asset increases drastically.
Covered calls are attractive because if the asset rises over the strike price, the buyer can exert the right to purchase the stock at the reduced strike price. Meaning the writer of the option will not profit from the movement of the stock over the strike price.
Also Read: Basic Options Trading Strategies You Need to Know
Implementing Options for Speculation
Options contracts enable investors to get a large exposure to an asset for a comparatively small price. If implemented in isolation, it can generate a large profit if a stock rises.
At the same time, they can also produce a total loss of the premium in the case a call option expires meaningless because the asset’s price is unable to go over the strike price.
The advantage of purchasing call options is the fact that risk is topped at the premium for the option.
Traders can purchase and sell various call options at the same time, forming a call spread. These will cap the prospective profit and loss but offer a cost-effective advantage for certain circumstances, rather than a single call option. The reason is that a premium taken from a single option’s sale balances out the premium for the other.
Options for Tax Management
Taxes are something nobody looks forward to paying, and some investors use options to modify the portfolio without purchasing or selling a particular asset.
We can look at an example of an investor that can have 100 shares of ABC stock and may be liable for a significant capital gain. In order not to initiate a taxable event, the investor can implement options to minimize the exposure to the particular asset without having to sell it. The only expanse for the investor is the cost of the options contract.
Best Time to Sell a Call Option
Investing in a call option can generate a profit if you are confident the specific asset will stay stable or rise to some extent in the future. The idea is that you are wagering that the price of the particular asset is not going to increase over the strike price of the options.
The advantage of selling a call option is the opportunity to make a profit from stocks that you already have in the portfolio. Traders get a premium for every stock promised in the contract.
However, there is a catch, you forfeit the opportunity to earn money if the price of the stock rises over the strike price because the call gets assigned. Normally the investor has to know that he has an obligation to sell the underlying security to the buyer if the call gets assigned.
If you have doubts about the future price of a stock in your portfolio, the option to sell a call option can get used. When an investor sells a covered call, plus the price of the asset declines, the premium will offset the losses. But selling a call will not safeguard against losing money.
Are Call Options Bullish or Bearish?
Selling call options gets classified as bearish, the reason is the fact the seller earn money when the shares do not rise. Buying calls is a bullish because the investor can profit only if the specific price of the shares rises.
Although the profits of a call buyer can be unlimited, a call seller gets limited to the premium they have receive upon the sale of the calls.
Conclusion
Having the right but not the obligation to purchase an underlying asset at a particular price in a specific time period is the nature of financial contracts named call options.
Options are typically speculative instruments that depend on leverage. The seller of a call option makes a profit by collecting premiums of the sale of options contracts. Traders can incorporate an investment strategy that incorporates a sell of option contracts and generate an income. But remember that being the holder of the options comes with a risk that the whole amount of the paid premium can get loss.
FAQs
What does it mean to sell a call option?
Selling a call option means investors are selling the right, although it’s not an obligation, to another investor to buy the asset at a set price before a specific date. The seller receives a premium for consenting to provide the asset for a prearranged price before an agreed-upon date if the buyer requires it.
When should you sell a call option?
Investors may decide to sell a call option because it offers an opportunity for making an income from expected fluctuation in the stock price.
Can you lose money selling call options?
Yes, the whole investment can get lost if the underlying stock doesn’t rise over the option’s strike price. This is a form of a bet in the market, investors that decided to sell a call option contract are predicting that the price will remain stable.
What is the risk of selling a call option?
When a trader sells the call but doesn’t possess the asset, and the call gets employed by the buyer, then he can stay in a short position in the stock. The risk is unlimited if writing naked calls, and this creates difficulties for investors.
