Beginner's Guide To Call Buying

The popular misconception that over 90% of all options expire worthless frightens a lot of traders and investors. They believe this statistic and conclude that, if they buy options, they will lose money 90% of the time. This is completely false. In fact, according to the CBOE, about 30% of options expire worthless while 10% are exercised and the other 60% are traded out or closed by creating an offsetting position.

This article focuses on the technique of buying calls and then selling or exercising them for a profit. We will not consider selling calls and then buying them back at a cheaper price - this is called naked call writing and is a more advanced topic. (To learn more, read Naked Call Writing or To Limit Or Go Naked, That Is The Question.).

"Trading a call" in this article refers to first buying a call and closing the position later - this strategy is called "going long" on a call. (To learn more about making money going long on a put, see Prices Plunging? Buy A Put!)

"Covering a call" in this article refers to the act of selling a call to someone in the market in exchange for the option premium. When you're buying a call, you will be paying the option premium in exchange for the right (but not the obligation) to buy shares at a fixed price by a certain expiration date. (If you need to brush up on the basics of option trading, see the Options Basics Tutorial.)

[Covered calls are a great way to generate income from options but there are countless other strategies that investors may want to consider. Investopedia's Options for Beginners Course will teach you how options work and outline basic and advanced strategies to put them to work. With over five hours of on-demand video, exercises, and interactive content, you'll learn everything from calculating breakeven points to exploring advanced concepts like straddles and spreads.]

The basic reason for buying a call is that you are bullish on a stock or other security. Why not just buy the stock and not worry about options? After all, stocks never expire while options do. So why consider an investment that has an expiration date? The most common reason is leverage.

Consider the following example: XYZ stock trades for $50. The XYZ $50 call that expires in a month trades for $3. Would you rather buy 100 shares of XYZ for $5,000 or one call option for $300 ($3 x 100 shares), considering the payoff depends on closing prices in a month? . (The example deals with a one-month option but options can last for different lengths of time. LEAPS, for instance, may expire in more than a year.)

Let's look at a graphic illustration of your choice:

As you can see, the payoffs for each investment are different. While buying the stock will require an investment of $5,000, you can control an equal number of shares for only $300 by buying a call option. Also note the breakeven price on the stock trade is $50 per share while the breakeven price on the option trade is $53 per share, ignoring commissions or fees.

The key consideration is that, while both investments have unlimited upside in the next month, option losses are capped at $300 while potential stock losses could skyrocket to $5,000. Keep in mind that buying a call option gives the holder the right but not the obligation to buy the stock so paid premiums are the maximum losses.

Close out your call position by selling it back to the market or having it exercised, in which case you have to deliver cash to the counter party who sold it. Say the stock in our example was trading at $55 near expiration. You could sell your call for approximately $500 ($5 x 100 shares), which would give you a net profit of $200 ($500 minus the $300 premium).

Alternatively, you could have the call exercised, in which case you would have to pay $5,000 ($50 x 100 shares) and the counter party who sold you the call would deliver the shares. With this approach, your profit would also be $200 ($5,500 - $5,000 - $300 = $200). Note that the payoff from exercising or selling the call is identical: a net $200 profit.

Trading calls can be a great way to increase exposure to a certain stock or other security without tying up a lot of funds. They are used extensively by funds and large investors, allowing them to control a large amount of shares with relatively little capital,. As you can see, trading calls can be used effectively to enhance portfolio returns.