Call options and put options are the two primary type of option strategies. Below is a brief overview of how to provide from using call options in your portfolio.
The Basic Call Option
A call option provides an investor with the right, but not the obligation to purchase a stock at a specific price. This price is known as the strike, or exercise price. Other important contract terms include the contract size, which for stocks is usually in denominations of 100 shares per contract. The expiration date specifies when the option expires, or matures. The contract style is also important and can be in two forms. American options let an investor exercise an option any time before the maturity date. European options can only be exercised on the expiration date. The settlement process must also be known, such as delivering the shares in the case of exercise within a certain amount of time. (Read Investopedia’s helpful clarification, “American vs. European Options.”)
Writing Call Options for Income
Buying a call option is the same as going long, or profiting from a rise in the stock price. As with stocks, an investor can also short, or write a call option. This lets him or her receive income in the form of receiving the option price, or the opposite of the long position. This means the call writer has the obligation to sell the stock to the call option holder if the stock price rises above the exercise price.
In writing call options, the investor who is short is betting that the stock price will remain below the exercise price during the term of the option. When this happens, the investor is able to keep the premium and earn income from the strategy.
Combining One Call with Another Option
To create a more advanced strategy and demonstrate the use of call options in practice, consider combining a call option with writing an option for income. This strategy is known as a bull call spread and consists of buying, or going long a call option and combining it with a short strategy of writing the same number of calls with a higher strike price. In this case, the goal is for a narrow trading range.
For example, assume a stock trades at $10, a call is purchased at a strike price of $15 and a call is written at $20 for a premium of $0.04 per contract. Assume a single contract for premium income of $4, or $0.04 x 100 shares. The investor will keep the premium income regardless of the situation. If the stock remains between $15 and $20, the investor retains the premium income and also profits from the long call position. Below $15, the long call option is worthless. Above $20, the investor keeps the premium income of $4 as well as a $5 profit from the long call option, but loses out on any upside above $20 as the short position means the stock will be called away from him or her.
The above call option strategies can be combined with a vast array of more exotic positions, but should provide a good introduction to the basics.
At the time of writing Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.