Stock Call Options Trading, A More Advanced Explanation.

Calls – The Basics

A call option is a contract that gives you the right to buy or sell a stock at a certain price, called the strike price, at a specified date in the future. The specified date in the future is called the expiration date. 

One call option contract gives you the right to buy or sell 100 shares of a stock. You can buy or sell a call option contract. One purchased call option contract gives you the right to buy 100 shares of a stock. One sold call option contract gives you the right to sell 100 shares of a stock. However, it is important to understand that this is a right to buy or sell a stock, and not necessarily an obligation. 

Options contracts can be bought and sold just like stocks. So, if you obtain the right to buy 100 shares of a stock in the future by purchasing a call option contract, you can give up that right at any point in time, by trading away that option contract on or before its expiration date.

Option contracts can only be traded during regular trading hours, which are typically 9:30am – 4pm EST. Option contracts can never be traded in after-hours. This is very important to understand.  

How Are Call Option Contract Prices Determined?

There are primarily two major factors that determine the price of an options contract. There are other more minor factors as well. We will discuss the two major factors and make mention of one of the minor factors.

The two major factors that determine the price of a call option contract include the price of the actual stock itself, and how far into the future you wish to trade a contract. The further into the future you look to trade a contract, the more expensive it will be. This is what is known as the option’s time value, which is referred to as the option’s “premium.” An option’s time value, or premium, can become temporarily inflated if a stock has a drastic change in price over a short period of time. However, for simplicity, we will ignore this stock volatility in discussing options pricing examples below.

Company ABC Is Trading At $15/share

Let’s assume that today is May 5, 2020 and a stock with ticker symbol ABC is trading at $15/share. Let’s take a look at what some call option contracts might look like for the month of June 2020.

Just like regular stocks, call options also have a bid and ask price. 

Buying Call Options

If you recall from earlier, the strike price refers to the price we’d like to have the contractual right to buy or sell 100 shares of a stock at. Looking at the Ask at the $13 strike price we see it is at $2.51. So it would most likely cost us $2.51/share for the contractual right to buy 100 shares of stock ABC at $13 on or by June 5th 2020. Keep in mind that the option contract price is shown on a cost per share equivalent basis. Since it is on a per share basis, an option contract with a price of $2.51 will actually cost us $2.51 x 100 shares or $251 in total to buy.

Now why is the ask price at $2.51? 

The answer is because stock ABC is trading at $15. The price of the option’s contract ($2.51) added to its strike price ($13) cannot be worth less than what the stock is trading at ($15) otherwise it would never make sense to buy stock. If that option contract was only trading at $0.51 it would be a steal to buy that contract. You would buy the contract, then exercise your stock option call contract early so that you could buy 100 shares of the stock at $13 (plus the $0.51/share you paid for the contract). Since the stock is trading at $15 right now, you’d instantly have a profit on your purchase. And so an option contract priced at $0.51 makes no sense at a $13 strike price for a stock that is currently trading at $15. 

Now let’s assume you pay the $2.51 to buy the $13 contract now and immediately ask to exercise your right to buy the stock at $13. What is the consequence of doing this? You buy the stock at $13, but the stock is currently trading at $15. Are you going to make a profit here?

NO!

You paid $2.51 to buy the call option contract. So even though you are buying the stock at $13, you have to factor in the cost of the call contract you paid for which is $2.51. So in actuality, you aren’t buying the stock at $13, you are buying it for $15.51. If you exercise your option to buy the stock right away, you have an immediate loss of $0.51c/share on your purchase. That $0.51/share cost over the current price of the stock is what we talked about earlier, and it is called the option’s premium value. Or in other words, $0.51 is the time value of that particular option.

As we get closer to the call option’s expiration date, which in this example is June 5th, the option’s premium value moves closer to $0. On the expiration date, the premium value actually becomes $0. So back to our example above, if we purchased the $13 contract for $2.51 and on June 5th, the day the option’s contract expires stock ABC is still trading at $15, how much will the $13 contract be worth on June 5th?

If you are following along, the option’s premium value drops to $0 on the expiration date. So the $2.51 $13 option contract is now worth only $2.00. Purchasing the option’s contract in May lost you $0.51/share, the cost of the option’s premium time value.

Now what happens on June 5th if stock ABC is trading at $16/share? How much will that $13 option you paid $2.51/share be worth?

The answer is $3. The price of the option’s contract plus the strike price ($13) can NEVER be worth less than what the stock is trading at when it expires. It can only be the same or slightly more. So in this case, if you wanted, you could exercise your right to buy the stock at $13 and turn around and sell it for $16 and have a $3/share profit. But remember, since you bought the option for $2.51 you have to add that to the $13 purchase price you paid for the stock. So you actually ended up paying $15.51 for the stock, and your profit is $0.49/share. Now if you recall from earlier, option contracts can be traded away at any time just like stocks. You do not have to exercise your right to buy the stock, you can simply trade your contract away. What would happen if you just traded your contract away the day it expired?

You would make the exact same amount of money as you would if you exercised your right to buy the stock. Your option contract that you paid $2.51 for is now worth $3. You can now sell the contract to someone else for $3 and make $0.49/share. That’s why there is usually, but not always no point to exercise your right to buy the shares.

A word of caution. If on June 5th, stock ABC is trading at $10, the $13 June option you paid $2.51 for would be worth $0. You would lose your entire investment in the contract.

Selling Call Options

Selling a call is essentially the same as shorting a stock.

What happens when you short 100 shares of a stock that’s trading at $10/share?

If the stock goes down to $5/share, you get to buy the stock at $5 and turn around and sell it to someone at $10 to make $500.

Now what happens if the stock goes up to $15? You are required to buy the stock at $15 and you must immediately turn around and sell it to someone at $10. You take a $500 loss!

Selling a call is no different. If you sell a $10 call for 50c in a stock with an option expiration date of September 15th, and on September 15th the stock is trading at $15.00, you must buy the stock for $15 and immediately turn around and sell it to someone for $10. This is because you sold someone the option to buy a stock from you for $10. So now you are forced to take a $500 loss on your position minus the 50c you got paid when you first sold the call. Alternatively, you can choose to buy back the call for $5 instead of buying and selling shares. But either way, you are still out $500.

It should be noted you can sell calls without owning any shares of the stock. This is called “naked call” selling. Typically stockbrokers do not let you sell naked calls unless you are a whale and your account has special privileges. The reason is, which you may have noted from the example above, is that selling naked calls can end up costing you everything you own if the stock goes through the roof. Our accounts do not have the special privileges needed to sell naked calls. So we do not have to worry about this.

Your broker will, however, let you sell “covered calls.” A covered call means a call you are selling against a position you already own. Often that position means you already own shares of the stock. So in the example above, if you already own shares in the stock and sell a $10 call for 50c, if on September 15th the stock is trading at $15 you don’t have to buy any stock to sell to someone. Instead, you just sell them the shares you already own. In other words, the shares you owed to someone else were already covered by what you had in your account. Alternatively, you could just buy the calls back if you want to get rid of them and not sell your shares to anyone. 

Now you do not have to own shares of a stock to be able to sell covered calls. You can actually buy call options and sell covered call options against the calls you bought. This type of trade is known as a vertical spread. You buy a call option at one strike price and then go ahead and sell a call option at a different strike price with the same expiration date as the call you just bought.

Let’s review the chart of options in Stock ABC that we looked at earlier but add another month of options to review this time. 

Let’s suppose it’s May 5th again, and this time we decide to buy the JULY $13 option instead of the June $13 option. We will most likely pay $3.01 for the July 13th option.

Since we now own a long (bought) call in ABC, if we’d like, we can now sell a covered call against our long. But we can only do this if we sell at a strike price that is the same or higher than the long call we bought in July. We can also only do this if we sell covered calls that expire the same month as our long call or in an earlier month than our long call. So when we buy the JULY $13 option for $3.01 if we want we can sell the $13 June option for $2.50 to get some of our money back, or better yet we can sell the $14 call for $1.75. So let’s pretend we do this. We buy the JULY $13 option for $3.01 and sell the $14 June call for $1.75. When we buy a call option for one strike date and sell a call option with an expiration date that is earlier than the one we just bought, we are making a vertical calendar spread trade as opposed to a vertical spread where the two options expire in the same month.

Now, let’s suppose on June 5th stock ABC is trading at  $14.50. What are the consequences of the trade we just made in May?

The consequences are nearly the exact same as they would be if you owned shares at $13 and sold the $14 call for $1.75. In the case of the shares, since you sold an option contract agreeing to sell the shares to someone at the $14 strike price, the shares would sell at $14.00 if you let them. But you still profit by $1.75, since that is the option contract fee someone paid to you for the right to buy your shares at $14. In the call’s only example, the $14.00 call you sold for $1.75 would now only be worth $0.50 at expiration. This is because an option contract’s price at expiration ($0.50) plus its strike price ($14) added together, must be equal to the price of the stock itself ($14.50). So in this situation, if you wanted to, you could buy the June call contract back to close out your contract and take a $1.25 gain on those calls. Alternatively, you could also sell the July $13 call that you initially bought and use that money to buy and close out the $14 June call for the $0.50. 

Now we can expand on this further. So let’s say on June 5th we just decide to buy back and close out the $14.00 June call for $0.50 but decide to hang onto our $13 July call. We now have the ability to sell another covered call against our $13 July call. We could sell and open up a $14 July call contract against our bought $13 July contract. If we played our cards right here, we could sell covered calls for July and come out even more ahead overall on our position.

POINTERS AND TERMS

When we own no shares of a particular stock and no option contracts for that particular stock, we are said to have no position in that stock in our accounts. If we buy shares in a stock, we are said to be opening a position in that stock. When we decide to sell our stock, we are said to be closing our position in that stock. Similarly, when we buy calls for the first time, we are said to be opening a position in calls. When we decide to sell back the calls that we bought we are said to be closing our position. Similarly, when we first sell covered calls we are said to be opening a position in covered calls. If for some reason we no longer wish to have a covered call position we will have to close the position out. If we sold to open a position in covered calls the only way to close the position out would be to buy it back. 

Important Questions You Need To Be Able To Answer And Should Fill In The Blanks Below

You should not be trading calls in any way shape or form until the following questions can be answered:

1). Assume you own 300 shares of stock ABC. You never sold any covered calls in stock ABC. At 4:15 pm company ABC announces that it is going bankrupt. Assuming the stock does not go to zero right away, could you sell your shares at 4:15, why or why not?

2). Assume you own 300 shares of stock XYZ and you sold 3 covered calls in stock XYZ for 40 cents. At 4:15 pm company XYZ announces that it is going bankrupt. Assuming the stock does not go to zero right away, could you sell your shares at 4:15, why or why not?

3). How much money is the following option contract worth? You bought a $22 call option expiring November 18th in the stock PHLP. On November 18th stock PHLP is trading at $29.40/share, how much is the $22 call option worth?

4). What is the worst thing that can happen to you when you buy a call option?

5). What is the worst thing that can happen to you when you sell a call option?

6). (Real Thinker) Imagine stock XYZ is trading at $15/share on June 1st. What are the risks and rewards associated with buying an October 1st $16 call option for $0.15 and immediately selling a September 1st $17 covered call option for $0.10?