Trading call options can be a great way to earn outstanding returns on your investments, as long as the conditions on which you buy or sell them are favorable. Call options are not always what they appear to be and the purpose of this article is to explain why.
But let’s start by defining some parameters. Call options allow you to “buy” the market to sell you an underlying asset, such as company stock, for an agreed price on an agreed expiration date. For this reason, call options increase in value when the underlying asset does, but not always at the same rate. Normally you would think about buying call options if you think the underlying stock or commodity is about to rise in price in the short term… and selling them when you think it is about to fall.
The other type of option you can trade is called a “put option” and is so named because it allows you to “put” shares on the market under the same terms as call options.
So what are the pros and cons of call options?
The advantages of calling options
1. Leverage – Options allow you to leverage your investment, effectively taking control over the fortunes of an underlying asset for a fraction of the cost of buying the asset itself. If you had the option until the expiration date (which most don’t) and it’s in the money, you would receive the same benefit as if you had bought the stock controlled by the options. So if your option contracts covered 1,000 shares and by the expiration date they had risen $5 in value, you would earn $5,000 minus the cost of the options.
2. Flexibility – There are a lot of option combinations you can take out, due to the fact that there are multiple option strike prices and expiration dates, also due to the fact that you can write (create) option positions and buy them. Add to this the complex way options are priced and you have an almost infinite number of possibilities when it comes to setting up your positions. Given the right conditions, you can sometimes take advantage of a trading opportunity with almost “risk-free” because of these variables.
3. Limited potential risk – unlike other derivatives such as futures, the most you can lose when you buy an option contract is the amount you have invested and no more.
The cons of calling options
1. Time Decay – For option buyers, the exponential rate at which an option’s value decays over the last 30 days of its life is their biggest enemy. For this reason, it is sometimes better to be on the sell side of an option contract, because the time decay then works in your favor. If you are a speculative trader buying calls on rising stocks hoping to make a quick profit of 30-100 percent or more, then you don’t want to hold it for very long, just a few days at most.
The exception to this would be buying a long option that is ‘very in the money’. In this case, the price of the option is made up primarily of intrinsic value and not ‘time’ and this gives you a bit more breathing room. You may also consider selling a short date option at a higher strike price in combination with this. It will reduce the total cost of the option in the long run should the underlying price fall, but it will also give you a nice profit if the price rises.
2. Complex pricing models – Call and put option pricing involves a number of components such as ‘intrinsic value’, ‘time value’, ‘probability’ and ‘implied volatility’. You may have heard of “The Greeks” regarding the options: delta, gamma, theta, vega, and rho. Each of these relates to the relationship of the option price to price movements in the underlying asset. If you buy a call option with high “implied volatility” and the stock price rises as expected, your option price may not rise accordingly. In fact, it could even remain unchanged or decrease if the IV component of the option price falls. It is important for traders to understand how ‘the Greeks’ affect the price of options.
3. In, In or Out of the Money – your choice of strike price (exercise) will affect the future performance of your call option position. Out-of-the-money options are usually much cheaper and if the underlying quickly exceeds the strike price, you can make a killing. But if the opposite happens, the value of your option evaporates very quickly. The same goes for at-the-money calls, but to a lesser extent. Once the ‘intrinsic value’ of the options is gone, all you are left with is the ‘time value’, a measure of the probability that the underlying will be above the strike price on the expiration date.
Therefore, a speculative trader must be very disciplined in setting loss limits on option trades. Best practice is to set an automatic stop loss at around 20 percent immediately after your trade has been accepted. This way you will avoid any emotional temptation to ignore it and you will probably suffer bigger losses later on. In this regard, ‘out-of-the-money’ options are not recommended, as their value declines faster than ATM or ITM options.
Buy options are great if you understand what you can do with them. An aspiring trader should become familiar with the pros and cons of call options, as well as the many options trading strategies out there, which are designed to minimize risk and maximize profit.