Finding the right balance between risk and reward can help you magnify your portfolio’s returns. One type of strategy is buying call options.
If you are trying to reduce your overall portfolio risk, buying call options is a low-risk, high-reward strategy.
In this article, you’ll understand everything you need to know about why buying call options is so important, the risks involved, and how to start buying calls on your own.
What Are Call Options?
A call option is a derivative contract that allows you to buy 100 shares of stock at a specific price (strike price or exercise price) on or before a specific date in the future (expiration date). One call contract equals 100 shares of stock.
There are two types of call options: American-style and European-style. American-style calls allow you to exercise or buy shares of the underlying stock at the strike price up until the expiration date. However, European-style call options enable you to exercise only on the expiration date. Most investors buy American-style options.
Buying a call option comes with many benefits. Let’s dig into why buying a call option can help you reduce risk and increase your gains simultaneously.
Why Buy Call Options?
Buying call options represents a bullish view on a particular stock, while a put option represents a bearish view of the underlying asset. For example, suppose XYZ Company expects earnings to beat the consensus estimate, or what analysts expect the share price to be in the future. In that case, you’ll have a bullish sentiment because the stock price rises after its earnings announcement.
Having a bullish outlook on an underlying security can enable you to experience attractive returns. We’ll explain why it is imperative to buy call options.
One of the significant benefits of buying a call option is that it allows you to increase gains based on the expected movement of a particular stock price. Call options permit you to buy shares at a fraction of the market price.
Another primary reason for buying calls is lowering your maximum loss. Buying stocks at a hefty price can cause you to lose a large amount of money if the stock tumbles. When you buy a call option, your maximum loss by expiration is only the premium you paid.
If you were to buy a call option, as its holder, you would profit when the underlying stock price is higher than the option’s strike price plus the premium paid. This is called the breakeven price. When the stock price does not increase above the breakeven price before expiration, then the call option expires worthless, known as “out of the money (OTM),” and you would then lose only the premium you paid for the options contract.
When the stock price increases above the breakeven price before expiration, the call option “is in the money,” and you would profit from the purchase of the call.
Consider this scenario, which illustrates your potential profit or loss. XYZ stock is selling at $40 per share and has a call option contract with a strike price of $50. The contract has four months until expiration, and the option premium is $3 per share, so a total of $300 for one contract.
For you to profit from the call option’s purchase, the stock price must go beyond the breakeven price of $53 ($50 strike price plus $3 premium). If the stock price rises to $60 on or before expiry, you will make a $700 profit.
In the end, your initial investment was $300 versus spending $5,000 to buy 100 shares of XYZ upfront, and you pocketed a nice profit! Even if the option did not expire in the money, you would lose only $300 of premium.
Downsides of Buying Calls
Even though the price of call options can be alluring, there are some downsides to consider before buying call options.
The rate at which the option’s time value decays during the last 30 days of its life is your number one enemy. The call option loses value in the last 30 days because time decay accelerates at a much faster pace when expiration approaches. In other words, when expiration starts creeping up, the value of the option will start losing money.
Many people may see buying call options as a gamble, which is not a valid assessment unless you treat it like a gamble. If you speculate and buy call options every week, you are taking a huge, unnecessary risk by thinking the price of the underlying stock will rise in such a short amount of time.
Deep Out-of-the-Money Calls
Deep out-of-the-money call options can be irresistible because they offer extremely low premiums. Lower premiums are the norm for deep OTM calls because the stock price needs to move excessively high to become profitable.
Say you buy a call for $2.05 with a strike price of $58, you would only pay $205 for the contract. However, the underlying stock price would need to soar past $60.05 before the option expires to be profitable.
No Dividends Received
You’ll receive no dividends as a call option holder. Call option buyers are not entitled to regular quarterly dividends. The price of the option becomes less expensive as the ex-dividend date approaches. However, the call option loses value in the days running up to the ex-dividend date, affecting your decision to buy the call.
How To Buy A Call Option
There are many ways you can buy call options. If you love DIY investing, you can open a brokerage account. Brokerages typically ask questions to see if you are qualified to buy call options.
Once you open a brokerage account and qualify, you can search for a stock you want to trade call options on. With a company stock selected, you will look at the options chain. The options chain is where all the call options are laid out. It shows the various strike prices, expiration dates, and volume on each call.
Before selecting which call contract to buy, you should look at the option’s premium. After choosing the call option contract to purchase, an options trade ticket opens, and you submit a buy-to-open order to purchase however many contracts you choose.
Time To Start Enhancing Your Returns
Balancing your risk and reward can help you sleep well at night. Buying call options is a strategy that can minimize risk and enhance returns.
We have covered how you can generate a profit while minimizing your loss. You should feel more confident on why buying a call option is essential for your portfolio, the downsides of buying calls, and how to buy a call option.
Are you ready to use some of the extra cash you have lying around to buy call options? What if you had a structured guide on how to find hot trades?
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