There's more than one way to play calls -- even if you're bearish on the underlying stock
Last week, we took a look at the two different types of options. This week, we'll continue our educational series by taking a look at three different ways to play calls.
Long Call
A long call option is one of the most basic option strategies. The buyer purchases a call option with the belief that the underlying stock is going to rally above the strike price before the option expires.
Example: Stock ABC is trading at $40, and a call option contract with a $40 strike price is priced at $2. If you believe that ABC is going to move well beyond the $40 strike, you could purchase a $40 ABC call option. With one contract carrying a price tag of $2, you would spend $200 ($2 premium multiplied by the 100 shares controlled by each contract). To give the stock time to advance, you purchase an option carrying an expiration date three or more months in the future.
Let's say your hunch pays off, and ABC rises to $50 by expiration. You might decide to exercise the option and purchase shares of ABC at $40 each. You can either hold the shares for a long-term investment, having acquired them at a discounted price -- or you can sell your 100 shares at $50 apiece, netting you a profit of $10 per share. This means that you have gained $10 per share on 100 shares, which comes to a nice profit of $1,000. Minus the $200 you paid for the original contracts, you are pocketing $800! That's a pretty nice little profit.
However, you don't have to touch the shares at all to cash in on a profitable call play. You can simply sell to close the option -- which, at expiration, would have an intrinsic value of $10 (stock price of $50 less strike price of $40). Accounting for 100 shares per contract, you would reap the same $800 net profit as in the example above.
Your maximum profit on a long call is theoretically unlimited, and gains are achieved when the price of the underlying stock (ABC in this example) advances past the strike price of the long call + the premium paid.
What if the stock falls? The most you can lose is your initial $200 investment, and you don't need to take any further action to exit the trade -- simply let the call option expire worthless. That's a far more palatable loss than if you had purchased $4,000 of the stock – right? Your maximum loss in this scenario is the premium paid, plus any commissions paid.
Call Spread
The bull call spread is an option trading strategy to use when you think the price of an underlying stock is going to advance moderately in the short term. To employ a bull call spread, you purchase an at-the-money (ATM) call option and sell a higher out-of-the-money (OOTM) call option on the same underlying stock with the same expiration month.
Example: Stock ABC is trading at $42, and you believe it will rally soon. You employ a bull call spread by purchasing a July 40 call for $300 and sell (or "write") a July 45 call for $100. Your net investment is a debit of $200 ($300 purchased less the $100 sold).
The stock advances to $46 by the expiration date, meaning both options expire in the money. The 40 call has an intrinsic value of $600, and the July 45 call has an intrinsic value of $100. This means that the spread is now worth $500 at expiration. Less the initial debit of $200, the profit is $300.
In other words, your maximum profit is the strike price of the short call, less the strike price of the long call, less the net premium paid. This best-case outcome is achieved when the price of the underlying stock settles at or above the strike price of the call you sold.
If the stock were to drop below the strike price of the lower (purchased) call, both options expire worthless. You would lose your initial $200 debit -- which represents your maximum loss.
Protective Call
A protective call, or short hedge, is a strategy using a call option on an underlying stock to cap the (otherwise unlimited) risk on a short sale. The call option offers protection against a rise in the market price of the stock shorted, as it establishes the maximum price to be paid in order to buy back the shares.
Example: You decide to sell 1,000 shares of ABC short when it is trading at $20.25. You are hoping to make a profit on a future decline in shares -- as selling them short will allow you to buy back the shares at a total price below $20,250 ($20.25 * 1,000), should they decline as expected. The risk is if the shares of ABC advance, this would cause you a substantial loss.
In order to hedge against a rise in the shares, you decide to purchase 10 ABC July 20 call options at $1.10 (a total cost of $1,100, after accounting for 100 shares per contract). Doing so assures you a purchase price of $20.00 per share of ABC if it finishes above this strike at expiration.
If ABC were to rise to $22.00, you would exercise the July 20 calls to buy the 1,000 shares back at the strike price. Using this scenario, your total loss would be limited to $850.00. That is the call premium ($1,100) less the difference between the price at which the shares were shorted and the strike price ($0.25 * 100 = $250).
Next week we will take a deeper look at some different ways to play puts, so make sure to check back and learn more about option basics. Remember, you can always take advantage of our Getting Started with Options home-study program -- click here for more information.