Introduction to Options #5 - Trading Call Options

Mechanics of call options


Call options are beneficial if you expect the price of an underlying asset to increase. While they offer potentially unlimited upside for profits depending how much the asset increases, downside is limited to the value of the option premium you paid. Unlike direct exposure to the asset, you give yourself time to weigh your rights over the asset at a fixed purchase price. The exercise price determines intrinsic value, albeit you need to add the option premium to establish the breakeven point.


Call options instead of direct investment


There are four key reasons to consider buying a call option over the underlying asset:

  • Timing benefits - a call option doesn’t require immediate action, you can make your decision to exercise the option or sell it at a later date

  • Fixed purchase price - you can lock in a purchase price for the asset, ahead of time and irrespective of subsequent price movements, should you choose to exercise the option

  • Limited risk - the monetary downside on a worthless option may be less than the potential losses if directly exposed to the asset, albeit the chance of the asset going to zero is remote

  • Leverage - you can increase your exposure because the option premium is denominated to a smaller scale than the asset, thus magnifying its movement in percentage terms, up and down



While there are benefits to calls, the risks revolve around neutral or negative movements in the asset price. Timing, normally a benefit, is also a risk on account of time decay and the time value lost as the option nears expiry, when only intrinsic value remains, or it is worthless since the asset is below the exercise price. A decline in implied volatility can also work against the option premium.


Choosing between call options


When you buy a call, you may choose the expiry date and exercise price, albeit should do so with regard to the option premium. You will want to establish the breakeven point, mentioned earlier.


In most instances, options with the lowest exercise price have the lowest breakeven point, but the highest option premium. In combination, a dearer option creates more downside risk under a falling asset price, although intrinsic value remains if the asset price remains above the exercise price.


Where an option has the highest exercise price, it will generally have the lowest option premium (all other things being equal). While significant gains can be made if the asset price increases, it may require a large and potentially unlikely movement.

Finally, an exercise price around the current market price might have an option premium somewhere in between the two extremities. However, this means it carries more time value as opposed to intrinsic value, so flat asset prices expose you to the largest losses.


To summarise:




The other consideration when buying an option is choosing the expiry month. Longer term options have a higher premium and breakeven point, which exposes you to more risk. However, they provide more time for an asset to rise and thus retain more time value, since decay is deferred.


To establish potential profits, you’ll need to estimate the share price at option expiry. On this date, the option will have no time value, only intrinsic value (if any). To make a profit, intrinsic value must be higher than the option premium, otherwise you will incur a loss.


Closing out a call option


At expiry, if the asset price is below the exercise price, the call expires worthless. Assuming the asset price is higher, at expiry, or beforehand, the option is in the money. You will need to gauge your willingness to hold the underlying asset:

  • If yes, you can exercise the option and buy the asset at the exercise price

  • If not, you will need to decide whether to roll it into another option, or sell the call

Call options can be sold, exercised or rolled over before expiry.


Selling before expiry is usually done to lock in profits from a rising asset price, since intrinsic value has risen. Also, there is still time value. If the option is out of the money, you may still choose to sell the call to mitigate your losses and recoup some proceeds via the option’s time value.


Exercising is generally done at expiry, so you make the most of the option’s time value, without having to lay out cash earlier than necessary. One instance you may choose to exercise early is when the option is well in the money, and the asset (share) will soon go ex-dividend.


Rolling your position closes your call but opens a new one at the same time. This is done prior to expiry - so some time value is preserved - in instances where you feel more time is required. The new call will have a longer expiry, with the choice to nominate a different exercise price.


When rolling over, if the exercise price is the same or lower, you will generally need to pay a cost difference between the premiums, which increases your breakeven point by that amount. If the premium is lower - sometimes for options with a higher exercise price - you may recoup some profits. In either case, buying more time may not necessarily be the best strategy, versus closing the position.


Summary


  • You generally buy call options when you expect asset prices and their implied volatility to rise

  • Call options provide time to weigh your rights over an asset at a fixed purchase price, plus limit your risk to just the option premium while still gaining leverage to unlimited profits

  • Risks concern neutral or negative movements in the underlying asset price, time decay until expiry, and a decline in implied volatility

  • A call option’s breakeven point is its exercise price plus its premium

  • Calls with the lowest exercise price generally have the lowest breakeven point and highest premium, and vice versa for those with the highest exercise price (high breakeven, low premium)

  • Long term calls have higher premiums and breakeven points - more exposure, but more time

  • At expiry, there is no time value in a call - profits are its intrinsic value less its premium

  • Calls can be sold, exercised or rolled over at or before expiry, depending if in the money or not

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