OPTIONS STRATEGIES: When and Why Should I Buy Call Options?

How to Trade Options featuring Buying Call Options

When you buy to open call options, you are making a bet that the underlying stock will rise in value. If you buy one call contract, you are essentially long 100 shares of that stock. As such, purchased call options are a bullish strategy.

To understand how buying call options might play out, let's look at an example.

Entering the Trade

You are bullish on Stock XYZ, which is currently trading at $50 per share. In an attempt to capitalize on higher prices during the near term, you decide to buy (to open) one call contract on XYZ.

You select a 45-strike call with two months of shelf life, which is asked at 7.45 (5 points intrinsic value + 2.45 points time value).

To purchase one contract giving you theoretical control of 100 shares, then, your initial net debit will be $745 (ask price of 7.45 x 100 shares).

By comparison, it would have cost you $5,000 to buy 100 shares of XYZ outright, based on a share price of $50.

Potential Gains

The potential profit on long call options is theoretically unlimited, as there's technically no concrete limit to how high the underlying stock can rise. However, it's probably fair to say you'd be happy with your bullish trade if XYZ rallied up to a reasonable $60 per share by the time options expiration rolls around.

With XYZ at $60, your 45-strike call would be worth $15 at expiration (15 points intrinsic value; no time value remaining). In order to collect your paper profit, you could sell to close your call contract for $1,500 (15 points intrinsic value x 100 shares).

Subtracting your initial net debit of $745, your profit is $755 -- or just over 101% of your initial investment. (Remember, this calculation does not account for any real-world brokerage fees.)

If you had simply purchased 100 shares for $5,000, your stake would now be worth $6,000. That's a profit of $1,000, or just 20% of your initial investment.

Alternately, rather than selling to close the option, you could exercise your option to buy 100 shares of XYZ at $45 each. After accounting for the fact that your contract cost $7.45 per share, you would be buying the stock at an effective price of $52.45 (strike price of 45 + premium of 7.45) -- a modest discount to the current market price. Plus, as a bona fide shareholder, you would be able to participate in any continued uptrend by the stock.

Potential Losses

To avoid taking a loss on the trade, you need XYZ to finish above the breakeven price of $52.45 by the time expiration rolls around (strike price of 45 + premium of 7.45). In other words, if XYZ closes anywhere at or below $52.44 upon expiration, you'll be swallowing a loss on your long call option.

However, losses are inherently capped when you're buying call options. Even if XYZ tanks to zero before your contract expires, the most you stand to lose is your initial investment of $7.45 per share, or $745. This entire loss will be realized if XYZ closes at or below the strike price of $45 upon expiration.

Volatility Impact

When you are trading long call options, be wary of stocks with high implied volatility readings (as compared to historical volatility). Since implied volatility is a key component in determining an option's price, it's more expensive to be a call buyer when implieds are running high.

Other Considerations

In addition to the usual factors that influence an option's price, call buyers should know that their options also price in the impact of any dividend payments to be issued during the life of the contract. Specifically, a scheduled dividend payment will lower the extrinsic value of call options offered in the relevant series, as the market anticipates a predicted ex-div decline in the shares. In other words, call holders won't benefit from dividend payments the same way a shareholder would.

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