Call option trading is only one side of the option trading coin and therefore only completes half the picture when it comes to the possibilities with options. Nevertheless, even on its own, call option trading can be a powerful ally.
The beauty of options trading is that you can take advantage of the market whichever direction the price action goes - up or down. For net debit positions, you normally use call options if you believe the price will rise, or in some cases, remain stable ... and put options if you believe the price will fall. For credit positions such as credit spreads, you do the opposite. So while our focus is on call options here, it's important to understand that it's only half the option trading story.
Call options allow the holder of the contract to buy an agreed number of an underlying financial instrument such as company stocks, for an agreed price, any time up until an agreed expiration date. At face value, it's as simple as that. But underneath this simple concept is a whole world of mathematical formulae. Fortunately for us, computer programs do all that for us these days and we just see the numbers. As your understanding of options grows, it's worth understanding what those numbers mean and how you can best utilise them to your advantage.
But coming back to the simple concept. If an option contract gives you the right (but not the obligation) to purchase stock at an agreed price, then that contract will increase in value as the underlying stock price increases. For example, if you have the right to buy shares at $25 when the price is $30 then you have $5 worth of intrinsic value in the contract. Should the price continue rising to $35, the fact that you can purchase the stock at $25 and immediately sell back to the market for the current trading price of $35, means that your option contract now has at least $10 of intrinsic value.
You get to control the fortunes (or otherwise) of an agreed number of shares for much less outlay than if you had actually purchased the shares. So if the stock price moves up by $5 you receive the benefit of that $5 times the number of shares the option contracts cover. Since your outlay has been much less than if you had bought the same number of shares, your return on risk is also much greater.
Ways to Use Call Options
The most obvious and straightforward way is simply to buy call options on an underlying stock, commodity future or whatever, when you believe the price will rise in the short term. Call options are rarely held to expiration date. You profit from the increased value of the options as the underlying price rises, by selling them back to the market. This is a simple concept whose main focus is simply on picking the right stocks at the right time. There are option trading courses which teach you how to do this using technical analysis of charts. It can be one of the most profitable ways to produce cashflow from the markets - but it also carries the highest risk.
These are generally a very stable and low risk call option trading method. The idea is that you purchase a given number of shares, usually in multiples of 100 and then sell call options on those shares. The sold options are 'covered' by ownership of underlying shares. But like any option trading strategy, there are different ways to set up your trades, depending on your personal style. You can explore this most interesting area by visiting our covered calls pages.
If you believe a stock price is about to fall, you call use call option trading to create credit spread positions. You sell call options at an exercise price at, or above, the current market price of the underlying and simultaneously purchase the same number of call options at a higher exercise price. Because the lower exercise price options will be more valuable, you take in a net credit.
As long as the stock price remains below the sold option exercise price by expiration date, you achieve maximum profit. If the underlying price action moves north, you will have the opportunity to buy back the spread for less before expiration date and profit this way too.
These work in reverse to credit spreads. You enter debit spreads when you believe the underlying price will rise. So you buy call options at an exercise price at, or above, the current market price of the underlying and simultaneously sell the same number of call options at a higher exercise price, for a net debit or cost. You achieve maximum profit if the underlying market price is above the sold exercise price at option expiry date.
Call option trading can also be adapted to more exotic option trading strategies such as calendar spreads and long condors. In the end, it all comes back to the simple principle that call options increase in value as the underlying financial instrument rises in price. After that, it's just a matter of whether you are on the buying or selling end of an option contract, or a combination of both, as to what your risk and potential reward profile will look like.
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