Call options gain value as a stock’s price increases. Option traders will buy calls when they think the underlying stock or index will move up. One of the most obvious advantages of a call option is that it is much cheaper to buy than buying the stock itself. However, like all options, you have to plan your trade to make sure you are not taking on too much risk.
[VIDEO] Understanding Call Options
A call option gives you the right to buy the stock for the strike price. In the chart below you can see Oracle Corp (ORCL) beginning to break out of a consolidation range in the direction of the prior positive trend.
In this case, you could have purchased a call option (ideally with a strike price as close to the current stock price as possible to take advantage of higher prices in the future).
In this case, the closest strike price to the stock’s price of $21.67 is $22 which would have given you the right to buy the stock any time before expiration for $22 a share. This call option would have cost you $.75 a share or $75 per contract. Expiration was June 20th, 37 days into the future.
Many traders assume that you must hold an option until expiration before harvesting profits. This is not the case. The call option itself will rise in value as the price of the stock moves, and you can sell it at any time before expiration and collect profits.
Going back to our Oracle example, as you can see in the chart below, the stock subsequently reached $23 a share, and by that time the option had increased in value to $1.05. That has created a profit of $.30 per option share, or $30 per contract, or an ROI of 40%.
- Bought 22 call on 5/13: $75
- Sold 22 call on 6/4: $105
- Profit: $30
- ROI: 40% ($30 / $75 = .40)
There are three things that you should learn from the example above. First, you can buy and sell an option contract whenever you want. You do not need to wait for expiration. Second, a call option’s value will rise and fall with the stock’s price. Third, the option’s price did not increase the same dollar amount as the stock. In this example, the stock’s price moved from $21.67 to $23 for a total gain of $1.33. However, the option only increased by $.30.
What causes an option’s price to grow at a slower pace than the stock’s is a factor called time value. In the video, we will talk about how time value works in the option market and why it is something you need to understand and plan for.
Image courtesy James Sarmiento.