How to Buy A Call Option
Buying A Call Option
Understanding Strike Prices When You Buy Calls
Example of How and When to Buy a Call Option:
Now that you have a better understanding of what options are, what calls and puts are, let's look at how to buy a call option in a little more detail.
How To Buy A Call Option
- Identify the stock that you think is going to go up in price
- Review that stock's Option Chain
- Select the Expiration Month
- Select the Strike Price
- Determine if the market price of the call option seems reasonable
To buy a call, you must first identify the stock you think is going up and find the stock's ticker symbol. When you get a quote on a stock on most sites you can also click on a link for that stock's option chain. The option chain lists every actively traded call and put option that exists for that stock.
When you request an option chain on the CBOE website for the stock that you want to buy a call, you will see the calls listed in the left column and the puts listed in the right column. To view other months you will have to toggle the "Expiration" drop-down menu.
First of all, you must realize that not all stocks have options that trade on them. Only the most popular stocks have options. Secondly, you cannot always buy a call with the strike price that you want for an option. Strike prices are generally in intervals of $5. So if YHOO is trading in the $30 range, it might have strike prices of $20, $25, $30, $35, and $40. Occasionally you will find $22.5 and $27.5 available for the more popular stocks. Thirdly, you will not always find the expiration month you are looking for on the option for which you want to buy a call. Usually you see the expiration months for the closest two months, and then every 3 months thereafter. Fourthly, even if you do find the option that you want to buy a call on, you need to make sure it has enough volume trading on it to provide liquidity so that you can sell it if you decide to. Most options are thinly traded and therefore have a higher bid/ask spread.
Finally, to buy a call you need to understand what the option prices mean and find one that is reasonably priced. If YHOO is trading at $27 a share and you are looking to buy a call of the October $30 call option, the call option price is determined just like a stock--totally on a supply and demand basis. If the price of that call option is $0.25 then not many people are expecting YHOO to rise above $30; and if the price of that call option is $2.00, then you know that a lot of people are expecting that option to rise above $30.
As you might expect, option prices are a function of the price of the underlying stock, the strike price, the number of days left to expiration, and the overall volatility of the stock. While the first 3 of these (stock price, strike price, and days to expiration) are easily agreed upon, it is the volatility and the expected volatility of the stock that traders differ in opinion and therefore drives prices. This is one of the most important things to understand when you go to buy a call.
Call and Put Option Trading Tip: When you buy a call option, you need to be able to calculate your break-even point to see if you really want to make a trade. If YHOO is at $27 a share and the October $30 call is at $0.25, then YHOO has to go to at least $30.25 for you to breakeven. This is because when YHOO is at $30.25, then you know that the $30 call is "in-the-money" $0.25 so it is worth at least $0.25 (your cost of the option). Likewise, if the October $30 call is $2.00, then YHOO has to climb to at least $32.00 for you to breakeven (when YHOO is at $32, then the $30 call is "in-the-money" $2.00 and it will be worth at least $2.00.)
Now let's look at a specific example of buy a call so this starts making sense. Let's say we have done our analysis on IBM and we think IBM will go from $84 to $87 in the next few days. Because I think IBM will go up I want to buy a call and since option strike prices are in multiples of $5, I could buy the $80 calls, the $85 calls, or the $90 calls.
Note from Table 1 below that the IBM April 85 Call has the greatest percentage return. Scenario 1--Buy 100 Shares of Stock, buy a call with a strike price of $80, buy a call with a strike price of $85, and buy a call with a strike price of $90. Now assume IBM Closes at $87. Notice in Table 1 that we spent $8,400 on the stock position and we spent very little on the options.
Now in the Table 2 below, we go ahead and invest the same initial amount in options as in the stock so we spend $8,400 on 100 shares, of IBM and about the same on each of the calls. Naturally, the percentage return is the same as in Table 1 above but since now look at the $14,000 profit on the April $85s! Even the profit on the April $80s is nice at $6,300. Are you starting to see the attractiveness of trading options and are you ready to buy a call!
Scenario 2--Invest Equal Amounts of Money in Each Stock and Option and IBM Closes at $87.
Now, here's the risky part of trading options. In Table 1 and Table 2 we showed the results assuming IBM climbed from $84 to $87 a share by the expiration date. Of course, stocks don't always move the way we think, so Table 3 shows what happens if the stock price just declines a bit to $83 a share. Note that for the $85 Call we lost all of our money, but for the $80 Call we only lost $2,100 and, of course, for the stock we only lost the $100. Now you see the risk that you take on when you buy a call!
Scenario 3--Invest Equal Amounts of Money in Each Stock and Option then IBM Closes at $83.00.
Buy a Call Conclusion: If you are sure that a stock is going to pop up a few points before the next option expiration date, it is the most profitable (and the most risky) to buy a call option with a strike price slightly higher than the current stock price. If you want to be a little more conservative, you can also buy a call option with a strike price below the current stock price.
When in doubt as to whether to buy a call with a low strike price or buy a call with a higher strike price, it is always good to look at the volume that is happening in the real market and go where the volume is (I call this following the "smart money").
Call and Put Option Trading Tip: Here is the one of the most important characteristics about option trading that you must know before you buy a call: Stock prices move in 3 directions--not only do stock prices move up and down, but they also can stay the same. If prices are random, then over a short period of time you would expect stocks to move up 33% of the time, move down 33% of the time, and stay roughly the same 33% of time. This is actually proven out by a lot of academic research that shows that buyers of calls and puts are only profitable about 35% of the time. So, if buyers of calls/puts are profitable only 35% of the time, that means that the sellers of calls and puts are profitable 65% of the time.
Now that you know how to buy a call and understand the importance of strike prices when you buy a call, the next topic addresses selling calls, also known as writing calls.
Here are the top 10 option concepts you should understand before making your first real trade: