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Call Options Explanation in Detail

By on February 20, 2013

A call option is a contract between you and the call writer guaranteeing to sell you a specific stock from here until a specific date at a specific price. Lets walk through some key terms associated with call options.

Ticker

A ticker is the stock that the contract represents. For example a call option on Apple would have the ticker AAPL. This is the same as when trading regular shares.

Strike Price

The strike price of a call options contract is the agreed upon price at which the option’s writer will sell you his shares from now until the date of expiration.

Expiration date

All call contracts have an expiration date. Typically expiration dates go by month and typically expire on the 3rd week of each month. Some options have what are called LEAPS which basically means an expiration of up to a year or two. While essentially the same as regular options they are more geared towards long term investors.

Premium

Nobody would guarantee you the right to their shares and forgo all their profits without getting anything in return. The person writing the call contract receives what is called a premium from you. What this basically means is that you are paying to ‘rent’ that person’s shares from now until expiration. The longer the time frame until expiration the more expensive. The closer a share is to the strike price the higher the price as well since the likelihood of you calling away that person’s shares and them missing out on the profits are higher.

Time Decay

Out of the money options (strike price above current stock price) and at the money options (strike price at or near current stock price) tend to depreciate in value day by day since the days allotted for the trade to go right are each day less and therefore make the option have less value to other traders. Deep in the money options (strike price deeply below current stock price) tend to not suffer from time decay as much given that they are already in the money.

So why do people write call options ?

Call options were created so that traders and investors alike can profit in sideways and down markets while giving others the ability to speculate on the direction of a stock. If you own 100 shares of stock XYZ trading currently at $35 a share and you feel the price will be rangebound near $35 for the next couple of months then writing a call option helps you get a small return on your investment meanwhile by receiving the premium. Writing call options also helps you hedge against a small dip in share price as the premium provides a margin of safety.

Trading call options

To trade call options you would need to be approved for options trading by your broker. A few brokers who offer this feature are etrade, TD ameritrade, options-house and others. Once approved for options trading you would select the ticker you want to trade options in and then select a strike price and expiration date by which your expected move in the stock will take place. Here is an example:

ABC is currently trading at $10 a share and you feel it could go to $20 a share from here to 6 months.

What you would do to profit from this move would be to buy a call option on ABC that expires on July 20 or later with a strike price of $20 or less. Typically the closer the strike price you buy to what the stock is currently trading at the safer you will be. Most new option traders shy away from in the money options because the price is so high however what they fail to notice is that the deeper an option is in the money (strike price is below the current trading price or in other words the option is already profitable) the less time value you are paying for it.

If you feel confident about where the stock will move then in this case a call option on ABC with a $10 strike price expiring on July 20 would be a really good choice.

Conclusion

Call options are a good way to gain additional exposure to a security. When trading call options it is important to consider the risks of time decay as well as acknowledge the fact that you are basically making a leveraged bet on where a security’s price will go. Options trading involves a high level of risk if proper risk management techniques are not practiced and are not suitable for all investors and traders.

This article originally published at The Street Options.

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