Buying or Selling Calls as an Investment Strategy
Call options on individual stocks or other types of securities provided an affordable and flexible way to benefit from an anticipated price increase. A call option gives benefits unavailable when buying the underlying security outright. As discussed earlier, the main benefits are leverage, income generation from an underlying security and a protection against sudden stock movement (insurance). These benefits should be relatively easy to understand. If you do not understand how and why an option gives an investor these benefits then see the overview article on options, which explains each in detail.
The first question most investors have once they understand options is, "When should I buy one". Let's go over two very specific situations in which a CALL option is an appropriate investment option:
It is important to note that any type of option can be PURCHASED or SOLD. They are not the same thing and much confusion comes from not being clear about this difference. Note that in the following examples we are BUYING a call in the first example, while in the second we are SELLING a call.
NAKED CALLS -- A naked call is a CALL purchased by an investor who has no holding or position on the underlying security. This strategy is called for when you feel very bullish on a particular stock yet lack the funds to invest outright or prefer to use an option as a viable investment alternative and understand the risks associated.
EXAMPLE -- Investor A works in the computer software industry and has recently worked with a revolutionary new database system that makes his or her work many times easier. He has heard other engineers share the same enthusiasm. After looking at the stock he discovers that the price has remained steady ever since the original release date for the new product. However, quarterly earnings come in later this month and they are rumored to be good.
He decides to act on his belief and makes a call to his broker and authorizes a purchase of an ABC Corporation Nov. 25th Call at $5.00 with a strike price of $50. The current price is at 48. The total cost for his option amounts to $500 ($5.00 x 100 shares = $500.00). He knows that if the stock is anywhere above $50 before or at the closing date of November 25th that he will be "in the money" and be able to benefit from the increase.
On Nov. 25th the stock is trading at $55.00 per share. Thus, his option of with a strike price of $50 has an intrinsic value of $5.00 ($55 (current price) - $50 (strike price)) per share. He sells the option on the open market and nets a profit of $450 (minus premium and various trading expenses).
COVERED CALLS -- Covered call is a bit different than Naked Calls. A covered call is essentially describing a situation in which an investor sells a call on a security he is already invested in. A covered call is typically employed by an investor who is neutral or somewhat bullish on the underlying stock; someone who would like to secure some of the money he has made on a stock and is willing to sacrifice some amount of future gains; someone who would like to generate income on one of the existing security position but doesn't want to sell any amount of the stock. All of these options are appropriate for covered calls. Let's do an example and illustrate how this type of option strategy works in practice.
EXAMPLE -- Investor B owns 1000 shares of XYZ Corporation, which is currently trading at $100 per share. The stock has been going up regularly for the last 6 months or so and B would like to benefit from this but doesn't want to sell the stock since it might go up even further. He calls his broker and his broker suggests that he might want to buy a Call option on the stock and gain income on the stock without having to sell any of his current holdings. B agrees that this is a good idea.
After checking price quotes on options for the stock, the broker finds a Nov. 25th call trading at a price of $5.00 with a strike price of $105. With the current price trading at $100 this option is already out of the money. By SELLING (note this is different than above where we are BUYING) one of these calls Investor B receives $500 minus expenses associated with the sale. Should the stock increase higher than $105 by the time the expiration date arrives Investor B will be ASSIGNED the stock and have to sell the shares at the agreed to price of $105. This means he can't benefit from a price increase above the $105. However, B is happy since he knows that he is gaining income now and that if the stock does go down he already locked in a good selling price.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.