Call Options are the most popular options traded. Knowing how they work is the first step to becoming a successful options trader.
So what is a call option? A call option is basically a bet that an underlying asset will rise in the short term. Let’s look at an example. Let’s say the price of Amazon is currently trading at $173.90; you think the price of Amazon will rise in the next 30 days.
So you buy a call option at $173.90 for $20.40 per share for 100 shares. These options expire in 14 days and cost you $2040.00 plus broker commissions.
14 days later the price of Amazon is trading at $205.50 and you decide to exercise your option to buy 100 shares at $173.90. This trade will cost you $17,390; you then decide to resell the shares on the open market for their current market price of $205.50, realizing a profit of $1120 after covering the cost of the options.
In the Money
In this scenario your trade is what’s known as, “in the money” since your strike price was less than the market price of Amazon and you made enough profit to cover the cost of the options and subsequent commissions.
This may seem like a fairly simple process but a lot’s going on in the background. When you place an option trade the dealer looks for another trader to take the other side of the trade. In other words for every call option there’s a subsequent put option in the same stock for the same amount.
This means every call option trade requires you the buyer (call holder), the broker who enables the trade to take place and the seller (call writer), who sells the option to you. The broker then has to find another trader to take the other side of the trade, which means another buyer (put holder).
This whole transaction involves around four people and only takes a few seconds to execute, thanks to the wonders of modern technology.
Of course this trade is unusual since we waited for the option to expire before we executed the trade. In reality this is unlikely as most options are sold back to the market well before expiry.
So don’t go thinking you have to have enough money in your account to cover the stock, since you’ll most likely sell your position long before it expires.
There is another scenario; you could keep the stock once you’ve exercised the option since it would already be showing you a profit. Many people choose to build their portfolio this way as it’s a good way of getting stock when it’s undervalued, even if you don’t have the funds available immediately.
Out of the Money
That’s all well and good if your options trade proves profitable, but what if it goes sour. What are your, ahem “options” then?
Well the beauty of options is you’re under no obligation to execute the options when they expire. You could just pass the option, in which case you’ll just have to cover the price of the options and not the underlying shares.
Also you can cancel out of the trade any time and sell it back to the market. In which case you’ll still make a loss, but only a small one.
You could even extend the option if you wanted too. You’d have to be sure of your charts though, don’t be tempted to run your losses. If a trade goes sour sometimes it’s best to just cut your losses and run.
As you can see options appear complicated at first, but once you know what’s going on in the background they become a lot easier to understand.
Options are one of the most popular securities to trade and should be part of any balanced investment strategy. They’re not the preserve of the rich; you only need to invest a couple of thousand dollars to get started.
If you’re new to options the best broker to start with is OptionsXpress. They have an excellent easy to understand trading platform as well as very comprehensive training and support.
Remember, trading options will require a small amount of dedication, but they can be mastered with a little effort on your part. Choosing a broker that will support you along the way is sure to increase your chances of success.