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Buying Call Options

On the menu of options opportunities, buying calls is a common one. That's true for investors who are new to options and those with years of experience. For one thing, call buying is relatively straightforward. That doesn't mean it's for everyone, though - before you jump in, become familiar with this required reading: Characteristics and Risks of Standardized Options.

With equity investments, the first step is to identify a stock or ETF whose market price you think will be higher in the relatively near future than it is now. Of course, it has to be one that options contracts are available for, but that's likely not a problem.

Next, you choose an options contract on the underlying equity based on strike price, premium, and expiration date. You are speculating that the market price of the stock will be higher than the strike price plus premium (and commissions!) before expiration. Otherwise, there will be nothing to gain if you exercise the option. Another approach may be to select a contract whose premium you expect to increase enough to provide a profit if you sell.

If you're right, you'll probably either buy the stock or, more likely, sell the contract. If you're wrong, all you'll lose is the premium.

Meeting Objectives

You can buy calls to meet a variety of investment objectives. Generally speaking, you buy calls if you think the market or underlying investment will increase in value.

For example, you might decide on a price that you would be willing to buy shares of a particular stock that you'd like to own. If you buy call options at that strike price, you don't have to pay for the full purchase price immediately. But you give yourself the opportunity to pay no more than the strike price if the market price rises above that level before expiration.

Alternatively, if you're interested in making money on the contract rather than buying the stock, you would buy a call on an option whose premium you expect to rise substantially in the short term. In this case, it's essential to pick a contract that will draw a lot of investor interest, since not all premiums move significantly even when the contract's underlying stock rises.

Many options investors sell their call contracts at some point before expiration, allowing them to realize a profit if the premiums have increased. On the other hand, if you've bought a call because you really want to own the underlying, you can exercise your right just as the term expires, subject to the exercise cut-off policies of your brokerage firm. The last trading day is the third Friday of the expiration month, but some firms may require more notice of your intent to exercise. The options actually expire on the Saturday following the third Friday of the expiration month.

Perfect Timing

Buying calls can provide different advantages depending on your time period:

  • In the short term, you can profit if you sell an option contract for more than you paid to buy it. That may happen if the price of the underlying rises quickly.
  • Over a matter of several months, you can use call options to minimize the risk of owning stock in a volatile market. If exercising doesn't make financial sense within a contract's term, you can always roll over the contract to lock in more time (by selling your current contract and buying a new one with a later expiration date).
  • Long-term equity anticipation securities (LEAPS), with terms up to three years, let you purchase calls at a strike price you're comfortable with while giving yourself enough time to accumulate the capital you'll need to purchase shares before expiration.

In each case, when you buy an option, you lose the premium you paid. You have a zero return if your call is out-of-the-money. Also, if your option is at-the-money, transaction fees may make it not worth exercising. But if your option is in-the-money, you should be careful not to let expiration pass without acting, because at minimum, your call will be automatically exercised.

Better than Margin?

For certain investors, buying calls is more appealing than buying stock on margin. Calls can provide a degree of leverage like you enjoy when you buy on margin, but require you to take less risk.

If you buy stock on margin, you must keep a reserve of cash and marketable securities in your margin account to cover possible losses. If the stock price falls, you must be able to meet a possible margin call, liquidate a portion of your assets, or face having your brokerage firm decide which of your assets to sell. In fact, you can lose more than the available equity in your account.

If you purchase calls, you have the benefit of low initial investment as you do when you trade on margin. But if the value of the underlying drops, as it always could, the main risk you face is losing your premium, an amount that's usually much smaller than the initial margin requirement.