I don’t trade options … but I think understanding this strategy is key to your education. So today we’ll dive into call options.
If you’re interested in options trading, do yourself a favor: learn the rules before you throw money at trades.
Some so-called gurus will tell you this is a ‘safer’ trading style … but there’s still plenty of risk, especially if you don’t know what you’re doing.
So how can you stay safer? Educate yourself. That means learning things like the difference between a call option and a put option, how order executions work, and different kinds of options strategies.
Why am I telling you this if I don’t trade options? Because I want you to find success as a trader … no matter what trading style you want to pursue.
I want to help you. Plenty of my Trading Challenge students are interested in options, and I’m happy to share some of the knowledge I have. The more informed you are, the better decisions you can make about whether this trading style is right for you.
In this post, I’ll offer some key basics of options trading. Here, you’ll get an overview of call options: what they are, examples, and key strategies.
Table of Contents
- 1 What Is a Call Option?
- 2 Call Option Examples
- 3 Buying a Call Option
- 4 Selling a Call Option
- 5 Writing a Call Option
- 6 4 Call Option Strategies You Need to Learn
- 7 Call Option Profit Calculator
- 8 How to Read Call Option Graphs
- 9 Trading Challenge
- 10 Conclusion
What Is a Call Option?
“Call option” might sound like a feature on an online dating app, but it’s actually one of the two key types of options trading (the other being the put option, more on that in a bit).
First off, what’s the definition of a call option?
You can think of a call option as a down payment on a trade you want to make in the future … but only if the price is right.
With a call option, you have a contract that gives you the ability to execute a buy order of a certain amount of stock shares at a certain price, within a finite time period. It’s kind of like calling dibs on a trade — but only if it meets certain criteria.
As the term ‘option’ suggests, you don’t have to go through with the order. The contract gives you the right — but not the obligation — to go through with the trade.
The Difference Between a Call Option and Put Option
As I mentioned above, a call option is one of the two main types of options. The other is a put option.
We won’t go too deep into put options in this post. But it’s handy to understand what they are and the key differences between a call option and a put option.
A put option is the opposite of a call option. Here, you actually hope the stock will drop in price.
- A call option gives you the right (but not the obligation) to buy a stock or security at a certain price, by a certain date.
- A put option gives you the right (but not the obligation) to sell a stock or other security at a certain price, by a certain date.
With both types of options, you have the option to execute at a specified price within a predetermined time frame. Both types of options have an expiration date. If you let them expire, the value is lost.
In both cases, traders don’t always buy call or put options with the intention of exercising them. They usually buy them so that they can sell them at a higher price before the expiration date.
Call Option Examples
The idea of a call option — and options trading in general — can seem pretty abstract. So let’s look at some examples of how transactions might actually play out.
Buying a call option starts with the belief that a stock or security will go up in price. However, it’s important to discern that this ‘belief’ shouldn’t be the result of your gut instinct or what you hope will happen.
Buying a Call Option
Say you want to buy 1,000 shares of Stock XYZ at $50 per share. Right now it’s trading at a different amount.
You think it could reach your desired price pretty soon … So you buy a call option stating that you’d like to buy 1,000 shares of Stock XYZ at $50 (that’s the strike price) within a specified time period.
With this call option, you gain the right (but again, not the obligation) to execute the order at the strike price within a specific time period. So even if the stock went up to $200 per share, you could still go through with the transaction for your agreed-upon price. You locked in that price.
There’s a catch, though. For every buyer there’s a seller. Nobody’s gonna let you lay claim on their shares for nothing. You gotta put down a premium — kinda like a down payment on the call option.
How much the premium costs depends on the order total. That’s the price of the options contract, and it gives you the rights discussed above. It’s also non-refundable. So you can change your mind or the stock may not do what you expect…
But if you don’t exercise the option, you don’t get this money back.
The idea is that if the stock goes up in price, you can purchase at the agreed-upon price before the set time period is up. From there, you could sell the stock and gain profits. Or, depending on the stock, you could hold it to try to maximize future gains.
Selling a Call Option
For every buyer, there’s a seller. So what happens when you’re selling a call option? Here’s the deal…
Writing a Call Option
This is a scenario where a seller — also called a writer — sells a call option hoping it’ll expire worthless. It’s a way to make money by keeping the premium or down payment.
4 Call Option Strategies You Need to Learn
Curious about some of the most common strategies traders use with call options? Here are four big ones.
#1 Covered Call
Also called a buy-write, this is one of the most common strategies for options trading. Here, you’re the person who owns the stock in question.
So you have the shares. You’re committing to sell the shares via a call option to generate income.
The idea is that you can generate extra income from the stock or asset by earning the options premiums if the buyer doesn’t exercise the options. In this scenario, you get to keep the premium. And you don’t have to let go of your shares at the specified price.
#2 Naked (Uncovered) Call/Short Call
With a naked call option, you as the option seller/writer are selling without actually owning the underlying stock. In this way, it’s similar to short selling — you’re using an asset you don’t actually own to try to generate profits.
If the buyer exercises the option, you have to buy the stock at the current market price to deliver to the buyer. As the seller, you’re not “covered” against losses. So if there’s a price spike, you gotta ante up for the shares and lose the difference in price. Not fun.
#3 Long Call
Here’s another common strategy for trading call options. And the long call is one of the most straightforward.
It starts with you as a buyer. You think the underlying stock will increase in value in the near future. So you buy a call option with a strike price that you think the stock price will exceed.
Then comes the tough part: figuring out a reasonable expiration date. Since the options contract has to have an expiration date, it’s a matter of choosing a date by which you think the price will increase.
Right now, there’s no outright purchase of shares. You’re only paying the premium. By doing so, if the stock increases in price, you can buy it for the price set within the set time period.
By only paying the premium, that can also free up more money that you can put toward other trades in the meantime.
What if the price doesn’t increase like you hope? That sucks … you won’t get your premium back. But that hurts less than buying a boatload of shares and having the stock not perform as you wanted.
Yes, there’s a risk, but it’s limited with this strategy.
#4 Call Spreads
The call spread is a little tough to understand at first … but stick with me.
This is a much more aggressive strategy. The idea is that you’ll sell a certain number of call options … Then you buy MORE call options of the same underlying asset, but with a higher strike price.
This is an aggressive approach, and it’s most appropriate for buyers who really, REALLY think the stock or asset will spike BIG soon. The call spread strategy generates maximum profits when the price has a big, fast spike — and the profits go up in kind.
Call Option Profit Calculator
However, it’s always a good idea to have a plan. That helps you understand how much profit you could reasonably make … and how much you could potentially lose. It helps you better prepare for entry and exit points.
Options can be extra tricky. There are a lot of moving pieces and factors to consider. So to help figure out a smart trading plan, it’s helpful to use a profit calculator.
There are a ton of free profit calculators online that have a call option formula. You can use them to help determine your profit potential. You enter details like the call option price, the number of contracts, the current stock price, strike price, etc.
This way, you can figure out your potential call option payoff. This can help you build a smarter trading plan.
How to Read Call Option Graphs
As you know, I’m all about charts, graphs, and figures.
In options trading, there’s something called a risk graph (or a profit and loss graph). It gives you a visual representation of the possibilities for profit and loss in an options trade.
A graph like this can help you create a more intelligent trade plan. There are options graph generators online, or your options trading platform may include charting software like this.
On a call option graph, the horizontal axis shows the stock price on the expiration date. The vertical axis shows the potential for profit or loss. It’s a good way to help you visualize and consider the best (and worst) case scenarios.
If you want to be a great furniture maker, you need to apprentice with a pro. If you want to be a pro athlete, you need to train with an expert coach.
If you want to become a great day trader, a mentor can help you on your journey.
I specifically focus on trading penny stocks … But you’ll learn plenty of basics that you can apply to a number of different trading styles.
You need to take the time to learn how trading works. That’s true no matter what type of trading you’re interested in — penny stocks, swing trading, options trading.
Plenty of traders like options trading. It can allow for flexibility, freedom, and the chance to minimize losses. But you need to understand the basics of options trading before you jump in.
I’m not an options trader or teacher. But since so many of my students are interested in options trading, I’m happy to offer guides like this to help you learn some of the basics.
Hopefully, this gives you a better idea of whether call options and options trading are strategies you want to pursue.
What’s your take on options trading? Tell me in the comments below… 👇 👇 👇