In a volatile market, options can be a good investment strategy to minimize the risk of owning a long stock - especially an expensive one like Apple. Apple's shares slid around 9.5% after announcing a cut for first-quarter revenue forecast, sending the overall market into a downturn as the Dow Jones Industrial Average tumbled over 2% last week.
But since investors have other options, what are call options? And how can you trade them in 2019?
What Is a Call Option?
A call option is a contract that gives an investor the right, but not obligation, to buy a certain amount of shares of a security or commodity at a specified price at a later time. Unlike put options, call options are banking on the price of a security or commodity to go up, thereby making a profit on the shares by being able to buy them later at a lower price.
There are many reasons to trade call options, but the general motivation is an expectation that the price of the security you're looking to buy will go up in a certain period of time. If the price of that security does go up (above the amount you bought the call option for), you'll be able to make a profit by exercising your call option and buying the stock (or whatever security you're betting on) at a lower price than the market value.
In essence, a call option (just like a put option) is a bet you're making with the seller of the option that the stock will do the opposite of what they think it will do. For example, if you're buying a call option for Apple stock at $145 per share and think it will go up to $147, you're buying the right to purchase those shares at $145 instead of the $147 you think they'll be worth by the time your contract expires. However, because you're only buying an option to buy shares later, you aren't obligated to actually buy those shares if the stock price didn't go up like you thought it would. But because you still paid a premium for the call option (essentially like insurance), you'll still be at a loss of whatever the cost of the premium was if you don't exercise your right to buy those shares.
In general, whether you are buying put or call options, the price at which you agree to buy the shares of the underlying security is called the strike price. For example, if you bought a call option for Amazon (AMZN - Get Report) at $1,574 per share, that would give you the option to exercise your contract and buy those shares at $1,574 per share - even if the market price went higher after you bought the contract. However, because you have the option (and not the obligation) to buy those shares, you pay what is called a premium for the option contract. So, whether you're buying a put or call option, you'll be paying a set premium just to have that contract.
Still, if a call option is the ability to buy shares later on, what's the difference between a call and put option?
Call Option vs. Put Option
While a call option allows you the ability to buy a security at a set price at a later time, a put option gives you the ability to sell a security at a set price at a later time. Unlike a call option, a put option is essentially a wager that the price of an underlying security (like a stock) will go down in a set amount of time, and so you are buying the option to sell shares at a higher price than their market value.
For this reason, call and put options are often bullish and bearish bets respectively. And while buying a call or put option may not necessarily correspond with a bull market or a bear market, the investor generally has a bullish or bearish attitude about the particular stock, which can often be affected by events like shareholder meetings, earnings reports or other things that might affect the price of a company's stock over a certain amount of time.
It is easier to think of a put option as "putting" the price of those shares on the person you are buying them from if the price drops and they have to buy the shares at a higher price.
How to Buy a Call Option
Still, how do you actually buy call options?
Well, call options are essentially financial securities that are tradable much like stocks and bonds - however, because you are buying a contract and not the actual stock, the process is a bit different. When you are buying a call option, you are essentially buying an agreement that, by the time of the contract's expiration, you will have the option to buy those shares that the contract represents. For this reason, what you are paying is a premium (at a certain price) for the option to exercise your contract.
A call option contract is typically sold in bundles of 100 shares or so, although the amount of shares of the underlying security depends on the particular contract. The underlying security can be anything from an individual stock to an ETF or an index.
As explained earlier, the price at which you agree to buy the shares that are included in the call option is called the strike price, but the price that you're paying for the actual call option contract (the right to buy those shares later) is called the premium. For example, you might pay a $9 premium for Nvidia (NVDA - Get Report) stock at a strike price of $135 per share, thinking it will go up over a set period of time. Call options generally have expiration dates on a weekly, monthly or quarterly basis.
You can buy options through a brokerage firm, like Fidelity or TD Ameritrade (AMTD - Get Report) , on a variety of exchanges. However, as a caveat, you must be approved for a certain level of options, which is generally comprised of a form that will evaluate your level of knowledge on options trading. There are typically four or five different levels, but will vary depending on the brokerage firm you work with.
Once you've been approved, you can begin buying or selling call options. However, you can also buy over-the-counter (OTC) options, which are facilitated by two parties - not by an exchange.
But, there's a bit more to a call option than just the strike price and premium - including how time value and volatility affect their price.
Time Value, Volatility and "In the Money"
The market price isn't the only thing that affects a call option - time value and volatility also play a large role in determining a call option's price or value.
Essentially, the intrinsic value of a call option depends on whether or not that option is "in the money" - or, whether or not the value of security of that option is above the strike price or not. For example, if you bought a call option with a strike price of $25 and the current value of the stock was at $27, your option would be "in the money" because it is immediately in profit (you can exercise your contract and make a profit right away). However, because "in the money" contracts have more intrinsic value, they are more expensive, so you'll be paying a higher premium for the call option. Conversely, "out of the money" call options are options whose underlying asset's price is currently below the strike price, making the option slightly riskier but also cheaper.
Time value, however, is the extrinsic value of that option above the intrinsic value (or, the "in the money" value). When purchasing a call option, that option's time value is essentially the time it has before it expires - the more time before the option expires, the more expensive its premium will be because it will have more time to become "in the money." Conversely, the less time an option has before its expiration date, the less time value it has and the cheaper its premium will be. For this reason, options are always experiencing what's called time decay - because they are always losing value as they near their expiration.
Additionally, much like regular securities, options are subject to volatility - or, how large the price swings are for a given security. For options, however, the higher the volatility (or, the more dramatic the price swings of that underlying security are), the more expensive the option.
One of the major advantages of options trading is that it allows you to generate strong profits while hedging a position to limit downside risk in the market.
Call Option Strategies
What strategies can you use when buying or selling call options? And how might different strategies be appropriate in different markets?
While there are lots of different call option strategies, here are some of the most used or simplest strategies.
1. Covered Call
One popular call option strategy is called a "covered call," which essentially allows you to capitalize on having a long position on a regular stock.
With this strategy, you would purchase shares of a stock (usually 100), and sell one call option per 100 shares of that stock. The benefit of this strategy is that you are essentially protecting your investment in the regular stock by selling that call option and making a profit when the stock price either fluctuates slightly or stays around the same. A covered call allows you to protect your investment by minimizing the losses of just owning traditional stock by selling a call option "out of the money."
Although covered calls have limited profit potential, they generally are used to protect a long position in a stock, even if the price goes down a little bit.
2. Long Call
One of the more traditional strategies, a long call essentially is a simple call option that is betting that the underlying security is going to go up in value before the expiration date of the contract. As one of the most basic options trading strategies, a long call is a bullish strategy.
Essentially, a long call option strategy should be used when you are bullish on a stock and think the price of the shares will go up before the contract expires. For example, if you bought a long call option on a stock that is trading at $49 per share at a $50 strike price, you are betting that the price of the stock will go up above $50 (maybe to trade at around $53 per share). In this particular example, the long call you are buying is "out of the money" because the strike price is higher than the current market price of the stock - but, because it is "out of the money," it will be cheaper. This is a good strategy if you are very bullish on a stock and think it will increase significantly in a set period of time.
The benefits of employing an option in this strategy is that it allows you to use minimal capital to trade a lot of shares of a security, rather than putting up the capital to buy a particular stock outright.
3. Short Call
A short call (also called a "naked call") is generally a good strategy for investors who are either neutral or bearish on a stock. However, it is often considered a more risky strategy for individual stocks, but can be less risky if performed on other securities like ETFs, commodities or indexes.
For a short call, you will sell a call option at an "out of the money" strike price (in other words, above the current market value of the stock or underlying security). For example, if a stock is trading at $45 per share, you would ideally sell a call option at $48 per share. However, because you are selling a call option, you are obligated to sell the shares at the low call price and buy back the shares at the market price (unlike when you just buy a call option, which reserves the right to not buy the stock).
Still, the max profits for this strategy are limited to the premium (which, since you're selling a call, you get immediately). With this strategy, you need to be relatively bearish on the stock or underlying security, because the underlying price must stay below the strike price. However, as a bonus, time decay is actually to this strategy's benefit - since, with selling a short call option, you want the option to be worthless at its expiration date (since you'll pocket the premium), so unlike other call option strategies, time decay generally works to your favor.
4. Long Vertical Spread (or Bull Spread)
If you're on the more conservative side and want to minimize risk (but also cap profits), a long vertical spread with a call is a good option strategy. The long vertical spread effectively gets rid of time decay and is able to be a generally safer bet than a naked call on its own.
Essentially, a long vertical spread allows you to minimize the risk of loss by buying a long call option and also selling a less expensive, "out of the money" short call option at the same time. For example, if a stock price was sitting at $50 per share and you wanted to buy a call option on it for a $45 strike price at a $5.50 premium (which, for 100 shares, would cost you $550) you could also sell a call option at a $55 strike price for a $3.50 premium (or $350), thereby reducing the risk of your investment from $550 to only $200. This strategy would then become a 45/55 vertical spread.
One of the benefits of a vertical spread is that it reduces the break-even point for your strategy, as well as eliminating time decay (because, even if the underlying stock price stays the same, you will still break even - not be at a loss). However, because the vertical spread generally bets on the price of the underlying security staying within a certain range, it has limited profit potential, so it may not be the best option if you are very bullish on a stock.
Call Option Examples
Here are some actual examples of call option strategies:
As explained in this article on options trading, a common call option strategy is a long call:
If you bought a long call option (remember, a call option is a contract that gives you the right to buy shares later on) for 100 shares of Microsoft (MSFT - Get Report) stock at $110 per share for Dec. 1, you would have the right to buy 100 shares of that stock at $110 per share regardless of if the stock price changed or not by Dec. 1. For this long call option, you would be expecting the price of Microsoft to increase, thereby letting you reap the profits when you are able to buy it at a cheaper cost than its market value. However, if you decide not to exercise that right to buy the shares, you would only be losing the premium you paid for the option since you aren't obligated to buy any shares.
Or, another example:
This involves buying a long call option for a $2 premium (so for the 100 shares per contract, that would equal $200 for the whole contract). You buy an option for 100 shares of Oracle (ORCL - Get Report) for a strike price of $40 per share which expires in two months, expecting stock to go to $50 by that time. You've spent $200 on the contract (the $2 premium times 100 shares for the contract). When the stock price hits $50 as you bet it would, your call option to buy at $40 per share will be $10 "in the money" (the contract is now worth $1,000, since you have 100 shares of the stock) - since the difference between 40 and 50 is 10. At this point, you can exercise your call option and buy the stock at $40 per share instead of the $50 it is now worth - making your $200 original contract now worth $1,000 - which is an $800 profit and a 400% return.
There are a lot of different strategies available when trading call options, so be sure to do your research and pick one that best suits your experience and attitude on the underlying security.