Options Trading Strategies
Buying Call Options
By buying call options, an option buyer has the right, but not the obligation, to purchase an underlying security (stock) at the strike price before the expiration date (for American style options). The call options are available in various strike price and call options expiration dates, which can vary from one month to more than a year (LEAP options).
A trader who is buying calls believes that the market will rise in the near future. By buying call options, a trader pays a premium and the premium is the maximum amount that a trader can lose. If, at the expiration date of the option, an underlying stock is traded below the strike price of calls bought (out-of-the-money calls), the calls will expire and be worthless. In that case, the trader loses all of the previously paid premium. On the other hand, the potential profit that could be made from the calls bought is considered to be unlimited. If, after a trader bought call options, the underlying stock rose strongly in price, the options may rise in price by 100%, 200% or even more. The stronger the upward rally is, the more valuable call options become. This is the main reason why bullish traders buy call options.
With American style options, a trader who bought calls has three ways of exiting the trade:
- The trader may wait until the expiration date and let the call expire. If an underlying stock is traded below the strike price, all of the premium is lost. If an underlying stock is traded above the strike price, the profit is equal to the difference between the current price of the underlying stock and strike price minus the previously paid premium.
- A trader can exercise the call to receive the stock at the strike price. As a rule, it is done when the underlying stock is traded above the strike price and the trader is willing to hold the stock in the expectation that will rise in price in the longer term.
- A trader can sell the call options in the same way in which they were bought. This is the most often used trading strategy that does not require additional capital (to buy underlying stock) and that allows one to save on brokerage commissions. At the same time this strategy allows one to limit losses if the underlying stock begins to decline.
Below you can see an example of a purchase of call options.
Let’s assume that QQQ (NASDAQ 100 tracking stock) stock trades at $40 and that a trader buys a QQQ call option with a strike price of $41 and one month to expiration at a price $1 (premium).
- If the stock goes to $43 in the next month, this trader can exercise the call option and demand that the call seller sell him/her the QQQ stock for $40. Then, this trader can sell the QQQ stock for a market price of $43 and keep the $3 difference per share of QQQ stock. If you deduct the $1 that was paid as a premium for the option, this trader’s final profit would be $2 per each share of QQQ stock - or 200%.
- On the other hand, if in the next month the QQQ stock declines to $38, it will not make sense to exercise the option and buy QQQ stock for $42 a share when it can be bought cheaper at the market price. In this case, the call options will expire worthless and this trader will lose the entire previously paid premium (a 100% loss).
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