Trading call options can be an excellent way of making outstanding returns on your investments, providing the conditions under which you buy or sell them are favourable. Call options are not always what they appear to be and the purpose of this article is explain why.
But let’s begin by defining a few parameters. Call options allow you to “call” on the market to sell you an underlying asset such as company shares for an agreed price by an agreed expiration date. For this reason, call options increase in value when the underlying asset does – but not always at the same rate. You would normally think of buying call options if you believe the underlying stock or commodity is about to increase in price over the short term… and selling them when you believe it is about to fall.
The other type of option you can trade is called a “put option” and named this way because it allows you to “put” shares to the market under the same terms as call options.
So what are the pros and cons of call options?
The Pros of Call 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 purchasing the asset itself. If you were to hold the option to expiry date (which most don’t) and it is in-the-money, you would receive the same benefit as if you had purchased the stocks that the options controlled. So if your options contracts covered 1,000 shares and by expiration date they had increased $5 in value, you would gain $5,000 less the cost of the options.
2. Flexibility – there are a vast number of options combinations you can take out, due to the fact that there are multiple option exercise prices and expiry dates, also the fact that you can write (create) options positions as well as buy them. Add to this, the complex way that 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 an almost ‘no risk’ trading opportunity because of these variables.
3. Limited Potential Risk – unlike other derivatives such as futures, the most you can lose when you purchase an option contract is the amount you have invested and no more.
The Cons of Call Options
1. Time Decay – for buyers of options, the exponential rate at which an option’s value decays during the last 30 days of its life, is your biggest enemy. For this reason, it is sometimes better to be on the selling end of an option contract, because time decay then works in your favour. If you’re a speculative trader who buys calls on rising stocks in the hope of making a quick 30-100 percent or more profit then you don’t want to hold it for too long – only a few days at most.
The exception to this would be buying a long dated option that is ‘deep-in-the-money’. In this case, the option price is mainly comprised of intrinsic and not ‘time’ value and this gives you a bit more breathing space. You may also wish to consider selling a short dated option at a higher exercise price in combination with this. It will reduce the overall cost of the long dated option should the underlying price fall, but also give you a good 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” with regard to options – the 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 moves upwards as you expect, your option price may not increase 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 option pricing.
3. In, At or Out Of the Money – your choice of exercise (strike) price will affect the future behaviour of your call option position. Out-of-the-money options are usually much cheaper and if the underlying quickly punches through the strike price, you can make a killing. But if it goes the other way, your option value evaporates very quickly. The same goes with at-the-money calls, but to a lesser extent. Once the ‘intrinsic value’ of the options disappears, all you are left with is ‘time value’ – a measure of the probability that the underlying will be above the strike price at expiration date.
So a speculative trader needs to be very disciplined when setting stop losses on option trades. Best practice is to set an automatic stop loss at about 20 percent immediately after your trade has been accepted. This way you will avoid any emotional temptation to ignore it and probably suffer greater losses later. In this regard, ‘out-of-the-money’ options are not recommended, as their value declines more rapidly than ATM or ITM options.
Call 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 option trading strategies out there, that are designed to minimise risk and maximise profit.