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:
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.
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.