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Buying Call Options

Options

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Call Options give the buyer the right, but not the requirement, to purchase an underlying asset at the exercise (or strike) price from the writer. The buyer hopes the market price will exceed the strike price plus cost of premium to reach “in the money” status. The writer hopes the market price will stay below the strike price plus premium cost, or the “out the money” status. In the money calls are worth more than out the money calls, and their value increases the further into the money they rise. Out the money calls are cheaper to buy. They decrease in price the further out the money they fall to offset the higher risk price they won’t reach “in the money” status. If they do reach “in the money” status, they will deliver higher profit.

Call Options are also more valuable if the exercise price is lower. A low exercise price is more likely to be in the money than a high exercise price. Higher exercise prices are less valuable. To compensate, premium prices are higher if the exercise price is lower. The premium paid decreases as the exercise price rises.

If call options are “in the money” the writer hopes the buyer won’t exercise the options. If the buyer exercises the call options, the holder must comply and sell the underlying asset, usually at a loss. If the writer does not actually own the underlying asset, they must buy the asset to complete the sale.

This strategy is bullish. Investors purchase calls if they expect the market price to rise. It’s great for those who want to own the underlying asset if it starts to increase in value, but don’t want to own it right now. The more likely the share is to rise, the more you may want to buy the underlying asset or own a call.

You will pay the premium if you want to own the option. The premium is paid to the writer, and is very small in comparison to the price of buying the underlying asset itself. Your downside as a call buyer is limited to the premium paid and any commissions incurred. This is your only forced expense; you’ll pay the strike price if you choose to exercise the option. Your profit is determined by this formula:

(Where market price is underlying price at any present point for an American style option, underlying price at expiration date for European style option, or average underlying price before expiration for an Asian style option)

The combined value of strike price, premium, commissions, and fees are your breakeven point. If the underlying asset’s market price exceeds the breakeven point, exercise the option, pay the strike price, and then sell the underlying asset and collect your profit. This is the true definition of “in the money”.

Don’t automatically decide to exercise. You may get a higher return by selling the “in the money” option versus exercising it and paying the strike price, commissions, and fees. In any case, you’re better off buying options with underlying assets you have strong evidence will increase in price in the future. High volatility is your friend here, especially if you buy American style options which can be exercised at any time.

If the strike price is below the breakeven point, you’re “out the money” and it will cost you more to exercise the option. If you hold the option to expiration your loss is only the premium paid. You’re not doomed; you can sell the option on the market to recoup some of your cost. The only problem is this requires someone buying your option, which requires them being willing to replace you in your problematic situation. If you own multiple calls you can sell some to lower your potential losses while keeping others in hope they turn profitable.

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Option Profit Diagram Example

  • As you move to the right the underlying asset increases in value. The left side is lower in underlying price, while the right side is higher in underlying price.
  • As you move to the top the trade increases in profit. The gray horizontal line is the profit/loss difference point, the zero line where there is no profit and no loss. Higher above the line is higher in profit, lower below the line is higher in losses.
  • The blue line is the profit/loss at expiration. The purple line is the profit/loss now. Eventually the curving purple line will become the blue line.
  • A flat blue line below the grey zero line indicates limited losses at expiration. A flat blue line above the grey zero line indicates limited gains at expiration. A blue line that slopes down infinitely off the chart represents unlimited losses, while a line that slopes infinitely up represents unlimited gains.
  • A preference for limited loss trades is strongly recommended, remember that an estimated 60% to 70% of retail trader options expire worthless when purchased since prices need a reason to move in the money. If you have limited gains, they should preferably be both more likely than and higher than your potential losses. Always manage risk carefully.
  • Option diagrams created by TDAmeritrade “ThinkOrSwim” platform.