If you’re going to trade covered calls, you’d better know what a call option is first and foremost. There are tons of complicated investing terms out there. Hopefully we can make it easy for you to understand one of them…a call option.
Put simply a call option is a financial instrument that allows the owner the right, but not the obligation, to ‘call away’ or purchase shares of stock at a set price, within a designated time frame.
For explanation purposes we’ll look at stocks, although options exist for other derivatives such as ETFs and indices.
Call options, as well as put options, are sold in 100 share increments known as a contract. One contract is equal to 100 options. So if you see an option that is priced for $1.00, in order for you to purchase that option it would cost you $100.00 ($1.00 x 100). This is especially important to pay attention to when placing an order. If an order to buy 100 contracts is entered, you actually are buying 1,000 options! Always remember 1 contract = 100 options.
So why do you have the right to call away the stock?
Let’s examine both sides of the transaction to better answer that question. To be a better investor you must understand that there are always two sides to every buy and sell order. The person going long on a stock believes the price will eventually rise some time in the future. However the seller thinks that the stock will soon lose it’s current value.
It’s just simple supply and demand.
What gives you the right to purchase the stock is the premium you pay to the owner. If you believe Microsoft is going higher you pay the owner of the shares a fee. That premium paid is for the opportunity to purchase the shares at a set price.
For example let’s say Microsoft is currently trading at $27.00. If you believe the stock is going to $30 you’d want to buy a call option at the $28.00 strike.
Why the $28.00 strike?
If you think the stock is heading higher you definitely want to buy it at a discount. Buying the call option at the $28.00 strike allows you to own the shares for $28 even if the price is higher.
The seller of those options believes Microsoft may head lower or stay the same in the future. This is the reason they would be willing to part with the shares for $1.00 more than they are currently trading (MSFT @ $27.00 / call option strike = $28.00). They could be looking to generate monthly income from the sale of the call options known as covered call writing.
Once the premium is paid to the seller of the options, you now have the right to buy shares of Microsoft for $28.00.
You are not obligated to purchase the shares of Microsoft however. If during the duration of the option contract the price of the stock never goes above $28.00 you can simply let the option expire worthless. After all, you’re not going to pay more than the stock is currently trading at.
It’s worthwhile to note here that the cost of the option is the maximum amount you can lose with this position. It’s for this reason many choose to purchase a call option when acquiring shares. They buy the shares at a discount with the hope of owning them at a much higher price.
How long do I have to decide?
Every option has an expiration date. This is the date at which the option contract expires and the two parties to the agreement no longer have any right or obligation. If you own the call option, the expiration date is the last day you can exercise the right to buy the shares and they last day the owner of the stock would be obligated to sell them to you.
Every call option is sold according to it’s strike and expiration.
Most options sold expire monthly, ending on the third Friday of every month. There are many options however that expire weekly and those options expire every Friday except for the third Friday of the month, where the monthly options expire. Weekly options give you only one week for the stock to make a move (or not). Implemented correctly they can provide great profit opportunities.
The premium buys time. The strike is your target.
In the example above, you purchased the $28 call option for MSFT. The $28 strike price would be available to buy every month.
Let’s say that you thought in March, Microsoft would be above $28.00. If you were to buy the March $28.00 call option you would have until the third Friday in March to exercise that option and buy the shares, before the options expire worthless.
It is this feature of options, the fact that they have an expiration date, that many investment funds and individuals consider them to be risky investment vehicles. The notion that you could potentially hold a stock indefinitely and never have a ‘realized loss’ sometimes passes as a safe investment.