Welcome back!
Today we're really getting into the meat of this thing. Specifically, we're going to discuss buying call options.
What we're going to discuss today
Quick review
Why would anyone want to use a call option?
What is a call option?
How call options work
Bringing back our pal Frank!
How much did Frank actually make?
Frank’s 3 Decisions
What the heck is:
ITM
ATM
OTM
Breakeven Explained
Discussion on Risk/Reward profiles
Homework!
Quick review
Call options are cool. They are the first half of the equation to becoming a proficient option trader. Call options allow you to take a bullish (upward) directional position in a stock for a small amount of upfront cash, with the potential for a large return.
With options you can buy just as easily as you can sell, and we're going to learn both ways to use them.
Call options, as you may remember from my previous post, are one of the two types of option types available to you.
Again, a call option is a contract in which the buyer of the contract has the right to buy a specific number of stock at a specific price, within a specific period of time. (That's a lot of specifics!)
Remember, you as the buyer get to choose all three of those elements:
How many contracts to buy.
What price you want the contract to be set at.
How long you want until expiration.
Do you remember what the three elements that make up an option contract are called? You can check back here if you don’t…
I'll wait… Oh good, you remember.
But we'll review them here anyway… just in case. They are:
Strike price
Expiration date
Premium
It's all coming back to you now right? Glad to hear it.
Alrighty then… ready?
Why would anyone want to use a call option?
Well there are a number of reasons to use a call option:
For leveraged returns
For Cash flow
Pure speculation
To sell shares
To play momentum
To hedge your risk
To trade a stock you wouldn't be able to normally afford.
As a combination trade
Because you're bullish on a stock
Because you're bearish on a stock
And the list goes on....
All these reasons and more just for call options. They can be extremely versatile. For me I think simple is best, and for that reason we'll stick to the basics. The main reason for buying a call would be for leveraging your return while lowering your downside risk. Sounds cool right?
Call options are probably the best way for a newbie to get their feet wet. They can be simple to understand, and thus simple to place a trade. That's why we're starting here. To get you better acquainted with options. And the best way to do that is to practice them.
Important Note: If you haven't signed up for my newsletter yet, now is the time. I talk about a trading practice program called Think or Swim. It's completely free and the best way to get more familiar with option trading. If you're already signed up, then you are freaking awesome.
(Get my newsletter now, I promise to never spam you. Ever.)
Moving on…
What is a call option?
Well… A call option is a contract in which the buyer has the right, but not the obligation to buy shares of stock in the company at a certain strike price, on or before the expiration date.
So, call options allow the buyer of the option to acquire shares at an agreed upon price (strike price), on or before the expiration date for a premium.
Call option sellers, on the other hand, are obligated to deliver a certain number of shares at a certain price, on or before expiration, and receive a premium.
How call options work
To demonstrate what this means for us, let's bring back our old pal Frank. (He was mentioned here)
Frank decides he's madly in love with the 'famous' XYZ company. He knows, likes, and understands the company well enough to make a trade on it.
He decides it's undervalued and expects it to increase in value in the near future. Frank goes to ThinkOrSwim and decides to buy a call option. Here's the trade he decides to make:
Frank can buy a call option on XYZ company for $2, with the strike price at $50, and an expiration date of a month from now.
Frank likes this one; (he expects XYZ stock to go to $55) so he purchases one contract.
Quick Quiz Question (QQQ)
How much did Frank spend on the option contract? (you'll find the answer below)
Now let's run a hypothetical scenario…XYZ stock has a good run up and hit's $55 a share. Frank thinks that's pretty good, so he decides to 'exercise his option'.
What does that mean? you may be asking…
Well, that means the seller of the option must now deliver Frank his 100 shares of XYZ for $50 a share. He can then turn around and sell those shares to the open market for $55 a share.
Make sense?
Note: this option would now be Considered 'In The Money' (ITM), because the stock is above the strike price and thus worth money. It's in The Money. Get it?
How much did Frank actually make?
Let me explain the math here, don't worry, it's easy!
Premium or cost of option = $2 (per share)
Option strike price is $50
Stock rises to $55 (yaay!)
So how much money did Frank make?
Frank's strike was $50, the stock rose to $55…
That’s right! Frank would have made $5 per share.
Frank's total return = $55 - $50
= $5
But hold on, Frank paid $2 to buy that option, don't we have to account for that?
We sure do, and we'd subtract it from our total return.
= $5 - $2
= $3 net return
So did Frank only make a measly $3 or are we forgetting something? Ah, that’s right! Each contract controls 100 shares so we need to multiply Frank’s return by 100 for every contract Frank owns.
In this case Frank only owns one.
Premium x 100 shares = cost
In our case; $2 x 100 shares = $200 (QQQ answer)
And Frank's return is done the same way.
= $3 x 100 shares
So, Frank's Net return = $300
Not bad Frank! See, easy peasy.
To give you something to write down:
Net return = ((Stock price - strike price) - Premium) x 100 per contract
Looks like this using the example above:
Net return = (($55-$50) - $2 ) x 100 shares
Net return = $300
Not so difficult, right?
How this would actually play out
Once Frank has bought the call option he has one of three decisions to make:
He can exercise the shares and immediately sell them back.
He can exercise the shares and keep ownership of the stock.
He can sell the call option.
Note: Because his option is ITM (in the money) it makes sense to do any of the three decisions mentioned above.
Decision #1
This is the decision he made in our example. The option contract is about to expire. Frank decides to exercise his call option. This means he exercises his right to buy the stock at his strike price of $50. Because the option contract controls 100 shares of stock, Frank would need $5000. So, he buys 100 shares of stock for $5000. The stock is now worth $55 a share, so Frank can turn around and sell his newly acquired stock for $5500 netting him the $500 profit. Then you subtract the cost of the option, which was $2 a share or $200, and we get Frank's actual return of $300!
Decision #2
The option is about to expire, and Franks option is currently worth $5, but he likes the stock and thinks it will continue to rise so he exercises his right to buy at $50, costing him $5000 to control 100 shares of the stock. The stock is currently selling for $55 so this trade results in a current 'Paper gain'* of $500
*Note: this is also referred to as an Unrealized Gain.
Decision #3
The option is again, about to expire, Frank simply decides to sell his Call option contract back to the open market. Because it already has an Intrinsic value of $5 (intrinsic value is something we'll get deeper into later) he can sell his call option for $5 and doesn't have to worry about the $5000 outlay that exercising his call required. His cost was still $2, so he receives the same return as 'Decision #1' but doesn't need the extra capital requirement. Pretty sweet right?
*This is the way I would do it. Once we get into how option contracts are priced you'll better understand why this may be the best choice for us.
How does Frank Know when to Exercise?
That's a good question. And one you should always know the answer to before you buy a call option. When am I going to sell?
Remember when we talked about the option being In The Money (ITM)? Well, the best time to exercise or sell an already purchased option contract is when it becomes profitable or is ITM and above the Breakeven point (which we'll discuss in a minute).
An option contract has three different states of profitability. It can be either:
In The Money (ITM)
At The Money (ATM)
Or Out of The Money (OTM)
Note: #1 & #3 are dependent on the type of option contract and directionality bias of the contract your trading.
Ex. Buying a call option is a Bullish type trade with upward directionality bias. Buying a Put option trade is a Bearish type trade with a Downward directionality bias. Therefore ITM and OTM are opposite for these two types of trades.
Again we're focusing on buying a Call option, so;
#1 ITM
We've already discussed this above, but again, ITM (when talking about buying calls) means that the stock price is currently above your strike price.
Ex. Strike price $50, Stock price currently $55.
#2 ATM
At The Money refers to the stock being priced at or slightly above or below your strike price.
Ex. Strike price $50, Stock price currently $50.
#3 OTM
Out of The Money refers to when a stock is priced lower than your strike price.
Ex. Strike price $50, Stock price currently $45.
These notations are fairly useless unless we consider the cost of our contract. The option contract could be classified as ITM, but if we sold, we still may not actually make any money!
Using the example above:
If Frank still had a Strike price of $50, and an option cost/ Premium of $2 anything below $52 would not make him any money.
This is called the Breakeven number and it's very important to calculate before doing any option trade.
Breakeven explained
If we were to define a breakeven point it would be; the point in an option contract when it actually becomes profitable to you.
Calculating breakeven is simple and straightforward when buying a call option.
It's your strike price plus your cost.
In the example above, Franks strike price was $50, and the cost of his option was $2. You just add those two numbers together to get your breakeven point
Thus $50 + $2 = $52
What this means
This means that for Frank to actually make any money on this trade, the stock has to rise above his breakeven point, or in this case, it must be above his $52 breakeven. This is important to know, because an option contract can still be ITM but not above the breakeven point.
It's called a breakeven point because if Frank were to exercise his contract at the $52 mark, he would neither make, or lose any money, and thus 'Breakeven'. Pretty easy right!
Quick Quiz Question (QQQ)
If the option is about to expire, At what price should Frank exercise/sell his call option?
(Hint: Not when it's OTM)
This is an important question, and also a fairly easy answer.
The best time to sell/ exercise the option, if it's nearing expiration, would be when the call is in the money enough to make some money. That would be a good time to exercise his call and then sell the shares immediately after, or just sell the call option you bought.
The other time to sell the call/ exercise the option would be if the option is ATM or slightly ITM. Again, you would sell the shares immediately after. This would help to make back some of the option cost making the loss less than if you let the option expire worthless.
Letting the option expire worthless makes sense when the option is ATM or OTM on expiration. This limits your downside risk to only the cost of the option contract which, in Frank's case, was $200.
A quick discussion on Risk/Reward profiles.
A risk/reward profile is exactly what is sounds like. It's how much risk and reward a potential trade can offer the investor.
For buying a call option:
Risk: limited to cost of the option
Reward: theoretically unlimited.
For Frank, the risk was $2 ($200 total) and the potential upside is theoretically unlimited, though the stock probably won't just keep going up and up and up forever. This is why buying call options are so tempting for people. It can be like buying a lottery ticket. The potential upside can be enormous, while the downside risk is limited to the cost of the ticket. The problem is, just like a lottery ticket, the huge upside rarely happens.
For a lottery ticket this is because it's nearly impossible to predict what numbers will be drawn. For a call option the difficulty is in knowing which direction the stock will move and when it will move.
The biggest limitation for buying a call option is that we have to be right, and we also have to be right within the specified time period.
So basically we have to be right, right now. That makes the odds lower that we are actually going to make any money.
This is why I prefer selling options. But, that my friends, is for another time.
Summary
Today we learned the basics of buying a call option.
We learned why they are used and the simplest way they can be used.
We talked about an example with our old friend Frank and calculated his return.
We learned that Frank had to know what decision to make and how he would choose to make it.
We also discussed what ITM, ATM, and OTM mean.
We learned at what point we actually start to be profitable (Breakeven point).
We had two QQQ's which you probably answered correctly!
And we briefly discussed risk/reward profiles.
Phew, that was quite a bit to go over in one day.
Great job making it this far!
Homework
It's time to take the next step.
This may be the most important step you take. Success looks like this:
Get the knowledge, use the knowledge, get the knowledge, use the knowledge etc…
Reading and learning about this is only half the battle, you still have to put it into practice or it just sits there in your brain, forever.
Today I want you to paper trade some call options. I recommend using ThinkOrSwim, as it's the best and easiest platform in my opinion, and it's free which is a bonus. Here's the link if your interested.
https://www.thinkorswim.com/t/innovation.html
I explain how to sign up in my newsletter, so if you're not signed up, do so now.
This is the first step on the path to success, you're getting the knowledge, now you need the tools to get you the practice, so you can begin using the knowledge.
Do it now! Don't wait.
Thanks again for reading this far.
We'll talk soon,
~Ryan Chudyk~
Welcome back!
Today we're really getting into the meat of this thing. Specifically, we're going to discuss buying call options.
What we're going to discuss today
Quick review
Why would anyone want to use a call option?
What is a call option?
How call options work
Bringing back our pal Frank!
How much did Frank actually make?
Frank’s 3 Decisions
What the heck is:
ITM
ATM
OTM
Breakeven Explained
Discussion on Risk/Reward profiles
Homework!
Quick review
Call options are cool. They are the first half of the equation to becoming a proficient option trader. Call options allow you to take a bullish (upward) directional position in a stock for a small amount of upfront cash, with the potential for a large return.
With options you can buy just as easily as you can sell, and we're going to learn both ways to use them.
Call options, as you may remember from my previous post, are one of the two types of option types available to you.
Again, a call option is a contract in which the buyer of the contract has the right to buy a specific number of stock at a specific price, within a specific period of time. (That's a lot of specifics!)
Remember, you as the buyer get to choose all three of those elements:
How many contracts to buy.
What price you want the contract to be set at.
How long you want until expiration.
Do you remember what the three elements that make up an option contract are called? You can check back here if you don’t…
I'll wait… Oh good, you remember.
But we'll review them here anyway… just in case. They are:
Strike price
Expiration date
Premium
It's all coming back to you now right? Glad to hear it.
Alrighty then… ready?
Why would anyone want to use a call option?
Well there are a number of reasons to use a call option:
For leveraged returns
For Cash flow
Pure speculation
To sell shares
To play momentum
To hedge your risk
To trade a stock you wouldn't be able to normally afford.
As a combination trade
Because you're bullish on a stock
Because you're bearish on a stock
And the list goes on....
All these reasons and more just for call options. They can be extremely versatile. For me I think simple is best, and for that reason we'll stick to the basics. The main reason for buying a call would be for leveraging your return while lowering your downside risk. Sounds cool right?
Call options are probably the best way for a newbie to get their feet wet. They can be simple to understand, and thus simple to place a trade. That's why we're starting here. To get you better acquainted with options. And the best way to do that is to practice them.
Important Note: If you haven't signed up for my newsletter yet, now is the time. I talk about a trading practice program called Think or Swim. It's completely free and the best way to get more familiar with option trading. If you're already signed up, then you are freaking awesome.
(Get my newsletter now, I promise to never spam you. Ever.)
Moving on…
What is a call option?
Well… A call option is a contract in which the buyer has the right, but not the obligation to buy shares of stock in the company at a certain strike price, on or before the expiration date.
So, call options allow the buyer of the option to acquire shares at an agreed upon price (strike price), on or before the expiration date for a premium.
Call option sellers, on the other hand, are obligated to deliver a certain number of shares at a certain price, on or before expiration, and receive a premium.
How call options work
To demonstrate what this means for us, let's bring back our old pal Frank. (He was mentioned here)
Frank decides he's madly in love with the 'famous' XYZ company. He knows, likes, and understands the company well enough to make a trade on it.
He decides it's undervalued and expects it to increase in value in the near future. Frank goes to ThinkOrSwim and decides to buy a call option. Here's the trade he decides to make:
Frank can buy a call option on XYZ company for $2, with the strike price at $50, and an expiration date of a month from now.
Frank likes this one; (he expects XYZ stock to go to $55) so he purchases one contract.
Quick Quiz Question (QQQ)
How much did Frank spend on the option contract? (you'll find the answer below)
Now let's run a hypothetical scenario…XYZ stock has a good run up and hit's $55 a share. Frank thinks that's pretty good, so he decides to 'exercise his option'.
What does that mean? you may be asking…
Well, that means the seller of the option must now deliver Frank his 100 shares of XYZ for $50 a share. He can then turn around and sell those shares to the open market for $55 a share.
Make sense?
Note: this option would now be Considered 'In The Money' (ITM), because the stock is above the strike price and thus worth money. It's in The Money. Get it?
How much did Frank actually make?
Let me explain the math here, don't worry, it's easy!
Premium or cost of option = $2 (per share)
Option strike price is $50
Stock rises to $55 (yaay!)
So how much money did Frank make?
Frank's strike was $50, the stock rose to $55…
That’s right! Frank would have made $5 per share.
Frank's total return = $55 - $50
= $5
But hold on, Frank paid $2 to buy that option, don't we have to account for that?
We sure do, and we'd subtract it from our total return.
= $5 - $2
= $3 net return
So did Frank only make a measly $3 or are we forgetting something? Ah, that’s right! Each contract controls 100 shares so we need to multiply Frank’s return by 100 for every contract Frank owns.
In this case Frank only owns one.
Premium x 100 shares = cost
In our case; $2 x 100 shares = $200 (QQQ answer)
And Frank's return is done the same way.
= $3 x 100 shares
So, Frank's Net return = $300
Not bad Frank! See, easy peasy.
To give you something to write down:
Net return = ((Stock price - strike price) - Premium) x 100 per contract
Looks like this using the example above:
Net return = (($55-$50) - $2 ) x 100 shares
Net return = $300
Not so difficult, right?
How this would actually play out
Once Frank has bought the call option he has one of three decisions to make:
He can exercise the shares and immediately sell them back.
He can exercise the shares and keep ownership of the stock.
He can sell the call option.
Note: Because his option is ITM (in the money) it makes sense to do any of the three decisions mentioned above.
Decision #1
This is the decision he made in our example. The option contract is about to expire. Frank decides to exercise his call option. This means he exercises his right to buy the stock at his strike price of $50. Because the option contract controls 100 shares of stock, Frank would need $5000. So, he buys 100 shares of stock for $5000. The stock is now worth $55 a share, so Frank can turn around and sell his newly acquired stock for $5500 netting him the $500 profit. Then you subtract the cost of the option, which was $2 a share or $200, and we get Frank's actual return of $300!
Decision #2
The option is about to expire, and Franks option is currently worth $5, but he likes the stock and thinks it will continue to rise so he exercises his right to buy at $50, costing him $5000 to control 100 shares of the stock. The stock is currently selling for $55 so this trade results in a current 'Paper gain'* of $500
*Note: this is also referred to as an Unrealized Gain.
Decision #3
The option is again, about to expire, Frank simply decides to sell his Call option contract back to the open market. Because it already has an Intrinsic value of $5 (intrinsic value is something we'll get deeper into later) he can sell his call option for $5 and doesn't have to worry about the $5000 outlay that exercising his call required. His cost was still $2, so he receives the same return as 'Decision #1' but doesn't need the extra capital requirement. Pretty sweet right?
*This is the way I would do it. Once we get into how option contracts are priced you'll better understand why this may be the best choice for us.
How does Frank Know when to Exercise?
That's a good question. And one you should always know the answer to before you buy a call option. When am I going to sell?
Remember when we talked about the option being In The Money (ITM)? Well, the best time to exercise or sell an already purchased option contract is when it becomes profitable or is ITM and above the Breakeven point (which we'll discuss in a minute).
An option contract has three different states of profitability. It can be either:
In The Money (ITM)
At The Money (ATM)
Or Out of The Money (OTM)
Note: #1 & #3 are dependent on the type of option contract and directionality bias of the contract your trading.
Ex. Buying a call option is a Bullish type trade with upward directionality bias. Buying a Put option trade is a Bearish type trade with a Downward directionality bias. Therefore ITM and OTM are opposite for these two types of trades.
Again we're focusing on buying a Call option, so;
#1 ITM
We've already discussed this above, but again, ITM (when talking about buying calls) means that the stock price is currently above your strike price.
Ex. Strike price $50, Stock price currently $55.
#2 ATM
At The Money refers to the stock being priced at or slightly above or below your strike price.
Ex. Strike price $50, Stock price currently $50.
#3 OTM
Out of The Money refers to when a stock is priced lower than your strike price.
Ex. Strike price $50, Stock price currently $45.
These notations are fairly useless unless we consider the cost of our contract. The option contract could be classified as ITM, but if we sold, we still may not actually make any money!
Using the example above:
If Frank still had a Strike price of $50, and an option cost/ Premium of $2 anything below $52 would not make him any money.
This is called the Breakeven number and it's very important to calculate before doing any option trade.
Breakeven explained
If we were to define a breakeven point it would be; the point in an option contract when it actually becomes profitable to you.
Calculating breakeven is simple and straightforward when buying a call option.
It's your strike price plus your cost.
In the example above, Franks strike price was $50, and the cost of his option was $2. You just add those two numbers together to get your breakeven point
Thus $50 + $2 = $52
What this means
This means that for Frank to actually make any money on this trade, the stock has to rise above his breakeven point, or in this case, it must be above his $52 breakeven. This is important to know, because an option contract can still be ITM but not above the breakeven point.
It's called a breakeven point because if Frank were to exercise his contract at the $52 mark, he would neither make, or lose any money, and thus 'Breakeven'. Pretty easy right!
Quick Quiz Question (QQQ)
If the option is about to expire, At what price should Frank exercise/sell his call option?
(Hint: Not when it's OTM)
This is an important question, and also a fairly easy answer.
The best time to sell/ exercise the option, if it's nearing expiration, would be when the call is in the money enough to make some money. That would be a good time to exercise his call and then sell the shares immediately after, or just sell the call option you bought.
The other time to sell the call/ exercise the option would be if the option is ATM or slightly ITM. Again, you would sell the shares immediately after. This would help to make back some of the option cost making the loss less than if you let the option expire worthless.
Letting the option expire worthless makes sense when the option is ATM or OTM on expiration. This limits your downside risk to only the cost of the option contract which, in Frank's case, was $200.
A quick discussion on Risk/Reward profiles.
A risk/reward profile is exactly what is sounds like. It's how much risk and reward a potential trade can offer the investor.
For buying a call option:
Risk: limited to cost of the option
Reward: theoretically unlimited.
For Frank, the risk was $2 ($200 total) and the potential upside is theoretically unlimited, though the stock probably won't just keep going up and up and up forever. This is why buying call options are so tempting for people. It can be like buying a lottery ticket. The potential upside can be enormous, while the downside risk is limited to the cost of the ticket. The problem is, just like a lottery ticket, the huge upside rarely happens.
For a lottery ticket this is because it's nearly impossible to predict what numbers will be drawn. For a call option the difficulty is in knowing which direction the stock will move and when it will move.
The biggest limitation for buying a call option is that we have to be right, and we also have to be right within the specified time period.
So basically we have to be right, right now. That makes the odds lower that we are actually going to make any money.
This is why I prefer selling options. But, that my friends, is for another time.
Summary
Today we learned the basics of buying a call option.
We learned why they are used and the simplest way they can be used.
We talked about an example with our old friend Frank and calculated his return.
We learned that Frank had to know what decision to make and how he would choose to make it.
We also discussed what ITM, ATM, and OTM mean.
We learned at what point we actually start to be profitable (Breakeven point).
We had two QQQ's which you probably answered correctly!
And we briefly discussed risk/reward profiles.
Phew, that was quite a bit to go over in one day.
Great job making it this far!
Homework
It's time to take the next step.
This may be the most important step you take. Success looks like this:
Get the knowledge, use the knowledge, get the knowledge, use the knowledge etc…
Reading and learning about this is only half the battle, you still have to put it into practice or it just sits there in your brain, forever.
Today I want you to paper trade some call options. I recommend using ThinkOrSwim, as it's the best and easiest platform in my opinion, and it's free which is a bonus. Here's the link if your interested.
https://www.thinkorswim.com/t/innovation.html
I explain how to sign up in my newsletter, so if you're not signed up, do so now.
This is the first step on the path to success, you're getting the knowledge, now you need the tools to get you the practice, so you can begin using the knowledge.
Do it now! Don't wait.
Thanks again for reading this far.
We'll talk soon,
~Ryan Chudyk~
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