What is a Call Option?

Source: Capital Pixel

Suppose you want to "play" the stock market but (alas!) you have limited funds.  Or, suppose you are pretty fully invested but are getting the heebie jeebies reading the news coming out of Europe or prognostications on the "fiscal cliff."  Or assume you are seeking a way to increase income produced by your portfolio.  One area you might turn to is options.

Options are used in various ways to gamble/speculate, hedge, and produce extra income - not all at the same time.  In fact, the investor who is selling the options against securities in his or her portfolio is selling them to the gambler or hedger, as the case may be.

To buy and sell options you should know that, even though you may have a brokerage account, it is likely that you aren't approved for options trading.  You'll have to fill out an application that seeks to ascertain you have the means and sophistication to trade options. Furthermore, we'll just look at Yahoo! here, but brokerages have options platforms that you'll need to get familiar with if you trade options.  For example, Schwab has "Options Express" that provides all kinds of tools for the options trader.

Joe Gets Going

So how do call options work?  Let's take the case of Joe, who has $500, and sees himself as a budding stock market guru.  He's done his research and has determined that Intel is ready to pop 5 points.  Joe does the math and calculates that his $500 can buy 20 shares and a 5 point pop would get him $100.

Although a great return, Joe is disappointed.  $100 is hardly sufficient compensation for the brainpower that has gone into the trade.  He looks around and somehow is able to open an options account.  He looks into call options.

So, Joe goes to Yahoo! Finance and clicks "Investing" and then "options," as shown.

Source: Yahoo

 CLICK TO ENLARGE   This takes Joe to the quote box below (Joe notices there are 2 quote boxes and is careful to put the ticker symbol in the appropriate box!):

Source: Yahoo

Joe takes note of the various resources  available below the quote box to check out later.













He clicks "Get Options" and this brings him to:

Source: Yahoo

CLICK TO ENLARGE Now Joe is getting into the nitty-gritty. He notices a price column headed by "Strike."  This is the strike price.  If the price of the security is above this price, it is "in the money."  For the strike price of $17, Intel at $26.06 is way in the money, to the tune of $9.06.

Here's the point that Joe needs to get:  if he owned a call option on one share of Intel at a strike price of $17, he could buy a share for that price and sell it immediately for $26.06.

In fact, what is done is the option itself is sold.  As shown, selling the option would get a bit more at $9.95.  This is because of another critical concept - expiration date.  Options in the U.S. can be exercised (i.e., sold) anytime at the discretion of the holder up until the expiration date.  Here the expiration date (actually at the close of trading today) is shown in the ticker symbol "INTC120721...".

Looking back at the last graphic, Joe notices the other expiration months.  He decides to check out "Jan 14."

Source: Yahoo

Here's where it gets interesting for Joe, aka "Da' Gambler" (hey... I'm just poking fun at Joe here - he's got better odds trading options than going to Vegas!).

He is interested in the Jan 30 calls at $1.38. With his $500, he can buy 3 call options (they come in 100 share units) to have the right to buy 300 shares of Intel anytime between now and the expiration date 1/18/2014, at $30/share.  Recall from above that, if he bought shares outright, he could only buy 20 shares!

If Joe is right, and Intel pops 5 points, Joe could make a decent return, especially if it happens soon.  If he holds on to the end and Intel is 5 points higher, his call option will actually be worth slightly less. One of the concepts every options trader needs to understand is how the premium due to the time value of money works.

Fred Writes Calls

What about the other side of the trade?  After all, someone is writing these options.  Let's check in on Fred.  Fred happens to own 300 shares of Intel.  He is happily collecting 3.2% dividend on his Intel shares and augments this return by selling call options.  This greatly enhances his return in a sideways or even down market.  Fred will lose out, however, if Intel does, in fact, "take off."  Suppose Intel spurts 10 points.  Fred will miss that because he will have to sell his shares at $30 to Joe.

Fred and Joe, of course, don't know each other - all of this takes place on a centralized exchange.

Sally Hedges

The final player in all of this is the hedger.  This is Sally (FYI:  academic studies prove women are better investors than men).  Sally bought Intel at $15/share (Sally gets a smiley face) and wants to protect her profit.  One way for Sally to do this is to buy a put on Intel with a strike price of $22/share, say.  Puts are the opposite of calls.  The put would give Sally the right to sell at the strike price any time prior to expiration.  She can use the put to lock in her profit.  This hedging obviously has a cost.

Other Stuff

I set up Joe as a stock picker.  Instead he may feel he can forecast the market.  Instead of call options on a stock like Intel, he would probably be more interested in a call or put option on  SPY, the exchange traded fund that tracks the S&P 500.

A couple of points about options for the beginner.  Fred is going to find that time goes by very fast when he speculates in options.  In other words, January will get here fast as he waits for Intel to take off.  Secondly, Fred should understand going in that there will be times when he is right (or at least guesses right) but his timing is wrong, i.e., Intel does go up big but only after the options expire (aargh!).  Also, options tend to confuse people because of the terminology.  Like other parts of the investment markets, they become clearer once you take a position.  If you do so, I suggest starting small and going slow.  It will appear that "out of the money" options are cheap.  They aren't.  It typically costs beginning options traders a few thousand in tuition to learn this.

I would also recommend reading at least one good book on options, especially if you are interested in going beyond the basics.  Options trading can get exotic fairly quickly with straddles, butterflys, strangles, etc.

Disclosure:  This post is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.