Retail investors, like institutional investors, can buy or sell call options to earn speculative profits or to hedge the risk of their portfolios. The strategies outlined here can help you increase the return on your portfolio and/or protect an existing short position that you might have.
Buying Call Options
Recall that a call option gives an investor the right to buy the underlying asset at a future date for a price specified today. Let’s assume that you observe a stock selling for $31 a share, and you believe the price will increase to $40 a share within the next few months. You note that there is a call option on the stock with a $35 strike price that expires in 5 months selling for $0.50 per option share. This means it will cost you $50 to invest in one call contract since standard option contracts are for 100 shares. If you are correct, and the stock price increases to $40 a share prior to your option’s expiration, you will be able to sell your option for at least its intrinsic value, which is the difference between the market price of the stock and the strike price of the option, or $5 per option share in this instance. Your profit on this transaction is a tidy $450: $500 – $50 = $450. Of course, if you’re wrong, and the stock price doesn’t even increase to $35 a share, you will have lost your entire investment of $50. Note, however, that the option premium will always be substantially less than the price of the underlying stock itself, so you can place a bet on a high-priced stock with a significantly fewer dollars than would be required to invest in the actual stock.
You can also use a call option to limit your risk exposure in a short sale. A short sale is the sale of stock you don’t own. You borrow the stock, through your broker, from another investor’s portfolio and sell it with the expectation that its price will fall, at which point you will buy it back and return it, profiting from the difference between the price at which you sold the stock short and the lower price at which you are able to repurchase it. Of course, if the stock price doesn’t fall as you expect and instead keeps rising, your losses could, theoretically, be limitless. However, if you purchase a call option on that same stock at the same time you execute the short sale, you will have locked in a price at which you can buy the stock in the future in the event the price goes up.
Writing Call Options
The investor who sells a call, also known as the call writer, receives the option premium and must stand ready to sell the asset to the owner of the call if the owner chooses to exercise his option. The cash received for writing calls increases the total investment income earned and, thus, the total return of a portfolio.
If you own the underlying stock, you are said to be writing a covered call. Alternatively, you can write a naked call, in which case you will be forced to purchase the stock on the open market if the call is exercised.
Writing a covered call on a stock when you expect its price to remain stable can serve to increase your investment income. As long as the price of the stock remains below the strike price on the call, the option holder will not exercise his option, and you will keep both the option premium and the stock. And if the price of the underlying stock drops, the option premium you received for writing the call will offset your loss on the stock itself. If the stock price begins to increase, you can always purchase an identical call option if you want to continue to hold the stock in your portfolio.
Obviously, naked call writing is the riskier of the two call writing strategies. Essentially, the naked call writer is betting the opposite of what the purchaser of the call is betting. The writer is betting the price of the underlying stock will be less than the strike price on the option for the duration of the exercise period on the option, in which case the call will not be exercised. The writer then keeps the option premium and hasn’t had to do a thing for it—except perhaps sweat it out for a few months. On the other hand, if the price of the stock increases and the option is exercised, the writer will have to buy the stock for the going price in order to fulfill his obligation.
Options Are Not For Everyone
Before you can begin executing these option strategies, you must be approved by your broker to buy and sell options. Most brokers have various levels of approval. For example, the lowest level may allow you to engage only in covered call writing. Qualifying at the next level might enable you to purchase calls, but you may have to be approved for a higher level to execute some combination trades involving options, and you will typically need to meet the highest approval level requirements to write naked options.