While the world of options investing can be quite simple or extremely complicated, when it comes to options there are only two basic types of options contracts.
The two types are known as calls and puts.
Having a thorough understanding of what these options contracts represent is imperative before one attempts to utilize them.
What Exactly Is a Call Option?
A call option gives the purchaser the right but not the obligation to purchase or be long the underlying instrument at a certain price by a certain date in the future.
It is very important to note that a call option represents the right only and may or may not be exercised.
What Markets Trade Call Options?
Call options are listed on various stocks, stock indices, futures markets, ETF's and more.
Some markets have very solid, liquid call option markets while others do not.
The degree to which call options are traded on an underlying instrument largely depends upon the amount of trading volumes and interest in that underlying instrument.
For the purposes of this presentation, we will focus solely on equity options.
Therefore, stocks that have good trading volumes and decent volatility are more likely to have more active call option trading than stocks with little volume and trading interest.
What Is The Strike Price of a Call Option?
Call options all have what is known as the strike or striking price.
This strike price is the price at which the purchaser of the call may exercise his or her call and buy or be assigned a long position in the underlying shares.
Strike prices are a key component of call options and are one of the most important elements of the call option pricing.
Let's take a look at an example:
Suppose that with shares of XYZ trading at $25 per share, an investor purchases a $27.50 call option that expires in one month.
This call option would give the investor the right but not the obligation to buy more shares at the price of $27.50.
Why might this be useful?
Well, there are numerous reasons but a very simple reason is if the investor thinks the shares may go higher but does not want to commit the necessary capital to purchase more outright shares.
Should the stock price move higher however, let's say to $30 per share, then the investor would have the ability to exercise his or her option and buy more shares at $27.50.
In other words, the option gives the investor another way to participate in potential upside in the stock without owning more shares directly.
All Call Options Have Expiration Dates
A listed call option will always have an expiration date.
These days, there are numerous expiration cycles to choose from.
Investors may utilize standard monthly options that expire the third Friday each month.
In addition, weekly options may now be used as well on many stocks and other products which expire every week.
Investors now have more ways than ever before to either hedge market exposure or speculate on potential upside in a market by using call options.
It is important to keep in mind that an option is a wasting asset.
Because options have expiration dates, they lose time value until they expire worthless or are exercised.
What Determines Call Option Prices?
Call options are priced according to several different factors.
Without getting into a detailed explanation of option pricing and theory, there are a few basics to keep in mind.
As previously discussed, a call option's strike price location will figure into the price for the option.
Deep in-the-money options will be more expensive than deep out-of-the-money options.
Call options are made up of two types of value known as intrinsic value and extrinsic value.
Intrinsic value is the amount that a call option is in-the-money while extrinsic value is comprised entirely of time value.
It is important to remember that time has a huge effect on option prices.
Because a call option is a wasting asset with an expiration date, the call option will lose time value on a daily basis all other things being equal.
The loss of time value is also exponential as expiration approaches, and a call option will lose value very rapidly going into the last few weeks before expiration.
Because of this, options that have more time until expiration will have greater values than options with less time until expiration all else remaining equal.
Another thing that can significantly affect call options is vega - or changes in implied volatility.
A rise in implied volatility or uncertainty in a market can drive option values higher.
A prime example of this is when a high flying stock is in rally mode for several days or weeks.
If one takes a close look at the call options, the values of the calls may increase quite a bit even without a large corresponding move higher in the shares.
This is because investors do not want to miss out on potential upside in the stock and are therefore willing to pay a premium for the calls.
Of course, there is a lot more to option pricing than this that is beyond the scope of this presentation, however, strike price, time value, and volatility are a few of the key components that determine an option's price.
Although we have referred to the call option value as price several times, another very well known term for an option value is called a premium.
In other words, a call option may be trading at a particularly high price or high premium.
These terms may be used interchangeably.
Call Option Advantages
Some of the biggest advantages of using call options are defined risk and smaller capital outlay.
When one buys a call option, the maximum risk is defined as the premium paid for the call.
For example, if shares of ABC are trading at $20 and an investor buys a front month $21 call for a premium of $.40 then that investor cannot lose more than the premium paid of $.40 regardless of what the stock does.
On the other hand, the investor has unlimited upside profit potential on the call should the shares really take off to the upside.
Call options are often bought as they can be less expensive than buying the outright shares.
For example, if an investor believes that a particular stock will soon be making a big move, but does not want to buy the shares outright because they are expensive, then the investor may elect to purchase a call option instead at a potentially lower cost.
By purchasing the call, the investor has upside exposure in the stock but has laid out less capital for that exposure.
There are numerous other benefits to utilizing call options as well based off of one's market outlook and strategy preference.
Call Option Disadvantages
The biggest disadvantage to buying call options is the enemy called time decay or theta.
Every day that goes by an option loses value all else remaining equal.
The clock is always working against an option buyer.
This means that to potentially make a profit, an investor must not only be correct about his or her market forecast, but must also correctly forecast the time frame in which this potential move will happen.
As if that is not enough, the call buyer must also monitor changes in vega or implied volatility.
If implied volatility levels drop, a call option may lose value all else being equal.
The buyer of a call option must correctly forecast direction, time, and volatility to potentially profit.
Many call buyers have experienced the frustration of being right about their market forecasts but their options have already expired.
Needless to say, it is not easy to get all three major aspects of a long call trade correct.
Leverage With Defined Risk
Call options can be very useful under the right circumstances.
These options allow an investor leveraged exposure in a market with defined risk exposure.
They allow unlimited upside profit potential as well.
It is imperative however, that investors understand the risks such as time erosion and lower implied volatility associated with buying calls and account for these risks when making investment decisions.
In the hands of investors with a proper knowledge and understanding of the risks, call options can be an extremely powerful tool to utilize in today's markets.