As your knowledge of puts and calls grows, you will want to consider trading strategies that can be used to make money in the options market. One of these is buying call options and then selling or exercising them to earn a profit.

Covering a call is the act of selling calls to someone in the market in exchange for the option premium. When you're buying a call, you will be paying the option premium in exchange for the right (but not the obligation) to buy shares at a fixed price by a certain expiry date. (If you need to brush up on the basics of option trading, please see the Options Basics Tutorial.)

Trading Calls: Is It My Calling?

The popular misconception that over 90% of all options expire worthless frightens a lot of investors. They believe this incorrect statistic and then conclude that, if they buy options, they will lose money 90% of the time! This is completely false. In fact, according to the CBOE, about 30% of options expire worthless, while 10% are exercised and the other 60% are traded out or closed by creating an offsetting position.

The focus of this article is the technique of buying calls and then selling them or exercising them for a profit. We will not consider selling calls and then buying them back at a cheaper price - this is called naked call writing and is a more advanced topic. (To learn more, read Naked Call Writing or To Limit Or Go Naked, That Is The Question.).

In this article the term "trading calls" means first buying a call and then closing out the position later - such a strategy is called "going long" on a call. (To learn more about making money going long on a put, see Prices Plunging? Buy A Put!)

The Underlying Idea
The basic reason for buying calls is that you are bullish on a stock. Why couldn't you just buy the stock and not worry about options? After all, stocks never expire - you could hold onto a stock forever - whereas options do. So, why consider an investment that has an expiry date? The reason is simple: leverage.

Consider the following example: XYZ stock trades for $50. The XYZ $50 call that expires in a month trades for $3. Would you like to buy 100 shares of XYZ for $5,000 or buy one call option for $300 ($3 x 100 shares)? One important thing to consider is that payoffs depend on closing prices a month from today. (The example deals with a one-month option, but you can have options that last for different lengths of time. LEAPS, for instance, expire more than a year away.) Let's look at a graphic illustration of your choice:

options_111401.gif

As you can see from the graph, the payoffs for each investment are different. While buying the stock would require an investment of $5,000, you could, with an option, control an equal number of shares for only $300. You'll also note that the break-even point on the stock trade is $50 per share, while the break-even on the option trade is $53 per share (ignoring all commissions).

The key point, however, is that while both investments have unlimited upside within the next month, the losses on the options are capped at $300, while the potential losses on the stock could go all the way to $5,000. Remember that buying a call option gives you the right but not the obligation to buy the stock, so your maximum losses are the premiums you paid.

Closing Out The Position
You can close out your call position by selling the call back into the market or by having the calls exercised, in which case you would have to deliver cash to the person who sold you the call. Say that in our example, the stock was at $55 near expiry. You could sell your call for approximately $500 ($5 x 100 shares), which would give you a net profit of $200 ($500 minus the $300 premium). Alternatively, you could have the calls exercised, in which case you would have to pay $5,000 ($50 x 100 shares), and the person who sold you the call would deliver the shares. With this approach, your profit would also be $200 ($5,500 - $5,000 - $300 = $200). Note that the payoff from exercising or selling the call is identical: a net of $200.

Conclusion
Trading calls can be a great way to increase your exposure to a certain stock without tying up a lot of funds. Because options allow you to control a large amount of shares with relatively little capital, they are used extensively by mutual funds and large investors. As you can see, trading calls can be used effectively to enhance the returns of a stock portfolio.

Related Articles
  1. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  2. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  3. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  4. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  5. Term

    What is Pegging?

    Pegging refers to the practice of fixing one country's currency to that of another country. It also describes a practice in which investors avoid purchasing security shares underlying a put option.
  6. Home & Auto

    Understanding Pre-Qualification Vs. Pre-Approval

    Contrary to popular belief, being pre-qualified for a mortgage doesn’t mean you’re pre-approved for a home loan.
  7. Investing Basics

    An Introduction To Structured Products

    Structured products take a traditional security and replace its usual payment features with a non-traditional payoff.
  8. Options & Futures

    Contango Versus Normal Backwardation

    It’s important for both hedgers and speculators to know whether the commodity futures markets are in contango or normal backwardation.
  9. Trading Strategies

    Why Is Short Selling Legal? A Brief History

    In the U.S., before a short sale can occur, broker/dealers must have reasonable grounds to believe that shares can be borrowed and delivered on time.
  10. Investing Basics

    What Does Contango Mean?

    Contango​ is when the futures price of a commodity is higher than the expected future spot price.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  4. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  5. How does a forward contract differ from a call option? (AAPL)

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  6. What are common delta hedging strategies?

    The term delta refers to the change in price of an underlying stock or exchange-traded fund (ETF) as compared to the corresponding ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center