- Nick Burgess
What Is A Call Option? Defining Risk in Options
One day, while perusing WallStreetBets, you likely came across someone that made $1 million in a day betting on Tesla stock. But how did they do it? Are you sure you want to read this? Alright, here we go: welcome to the wonderful world of stock options, the crack pipe of the stock market that's been handed to anyone with a Robinhood account and a poor understanding of margin loans. Please, please, please, for the love of god, do not take this as investment advice. Diving into a career as an options trader can be incredibly risky, and a few taps on your phone can lead to substantial risk and loss of assets, so please do as much research as humanly possible before jumping in. Now with that, let's cover options trading, specifically call options on the open market. Don't say I didn't warn you.
What Is A Call Option?
Call options are a type of financial contract that give the buyer the right, but not the obligation, to buy a specific stock at a predetermined price within a specified time frame. Options trading either a call option or a put option, can be a complex and risky investment strategy, but can also offer opportunities for additional income and potential profit.
The buyer of the call option pays a premium to the seller for the option, and if the share price rises above the predetermined price, the option holder can exercise the option and buy shares of stock at a lower price. The specified price, also known as the strike price or exercise price, is a predetermined price at which the option can be exercised.
Options contracts have an expiration date, which is the date by which the option must be exercised or it becomes worthless. The expiry date can be any time in the future, ranging from a few days to several years from the date the option was purchased.
Types of Options Contracts
There are two main types of options contracts: American options and European options. American options can be exercised at any time before the expiration date, while European options can only be exercised on the expiration date. In practice, most options traded in the United States are American options.
Why Place Call Options?
Call options are a way for investors to profit from a stock price increase without having to buy the stock outright. This makes them a popular tool for speculators and hedgers alike. Speculators hope to profit from the price increase, while hedgers use options to protect their positions against potential losses.
For example, let's say an investor believes that Reliance Industries is going to announce a positive earnings report that will cause the stock price to rise. The investor could buy a call option on Reliance Industries, which would give them the right to buy shares of the stock at a predetermined price within a specified time frame. If the investor's prediction is correct and the stock price rises above the predetermined price, they can exercise the option and buy shares of the stock at a lower price. The investor can then sell the shares at the current market price, realizing a profit.
However, if the investor's prediction is incorrect and the stock price does not rise, the call option will expire worthless and the investor will lose the premium they paid to purchase the option. This is an important factor to consider when trading options, as there is always a risk of loss.
How Do Options Make Money?
The price of the underlying asset is a key factor that affects the value of an option. For example, if the price of Reliance Industries stock is currently trading at $100 per share and the strike price of the call option is $110, the option has no intrinsic value. However, if the stock price rises to $120 per share, the option now has an intrinsic value of $10 per share, as the option allows the buyer to buy shares of the stock at $110 per share and sell them at the current market price of $120 per share.
In addition to intrinsic value, options also have time value, which is the value that comes from the possibility that the stock price will rise before the option expires. As the expiration date approaches, the time value of the option decreases, as there is less time for the stock price to rise.
Volatility is another factor that affects the value of options. Higher volatility generally leads to higher option prices, as there is a greater chance that the stock price will move significantly before the option expires.
Options trading can be used in a variety of strategies, such as the covered call strategy and the long call strategy. The covered call strategy involves selling a call option on a stock that the investor already owns.
Now that we've covered the basics of call options and their various intricacies, it's important to understand the risks associated with trading options. Trading options is not without its dangers, and it's essential to recognize these risks before diving in.
The Risks of Options
The primary risk associated with call options is the possibility of losing your initial investment. When you purchase a call option, you pay a premium upfront for the right to buy the underlying asset at a specific price at a later date. If the stock price doesn't rise above the strike price, the option will expire worthless, and you'll lose the premium paid.
Additionally, options trading involves substantial risks, including the potential for substantial losses. The price of the underlying asset can change rapidly, and the value of the option can decline just as quickly. This means that options trading requires a great deal of skill, discipline, and risk management.
Popular Options Trading Strategies
One of the ways to manage risk in options trading is to use a trading strategy called the covered call strategy. The covered call strategy involves owning the underlying asset and selling call options against it. This strategy can help to reduce the risk of loss by generating additional income from the premium received from selling the call option. It's also simple enough to understand and generate a bit of extra cash in your account, which is probably why you've seen it all over Tik Tok in recent years with the logic of "if this 13 year old with 5 monitors can figure it out, I probably can too!"
Another strategy that options traders use to manage risk is the long call strategy. The long call strategy involves purchasing a call option in the hope that the stock price will rise above the strike price before the expiry date. This strategy allows traders to take advantage of potential price rises while limiting their risk to the initial investment made.
It's essential to understand that trading options is not a get-rich-quick scheme. Like any investment, it requires careful consideration and analysis. It's crucial to conduct thorough research on the underlying asset and the options contract before making any trades.
In conclusion, call options are an excellent tool for traders looking to speculate on the future price movements of an underlying asset. They provide a way to potentially profit from a stock's upward price movement without owning the stock outright. However, options trading is not without its risks and requires a great deal of skill and discipline to be successful. By understanding the various intricacies of call options, their associated risks, and utilizing appropriate trading strategies, options trading can be a valuable addition to any investor's portfolio.