Understanding Options: Call Option

Hello, Power Profit Traders!

We use a lot of options in our trading. If you want to capitalize on options, you’ll simply want to feel comfortable using them. Let’s start with a Call Option and focus on the basics.

First, let’s learn some definitions about Call options.

Definitions

Call Option

A contract between a buyer and seller to exchange shares of an underlying security at a fixed price on or before a fixed date.

Strike Price

A pre-established price that allows a Call buyer to acquire shares of an underlying security from the Call seller. Call buyers can select a strike price, but cannot determine or change the strike price.

Premium

The per share dollar amount, not including broker fees, the buyer pays (ask price) and the seller receives (bid price) for the Call contract. Per share premiums are ordinarily multiplied by 100 for each individual contract bought or sold.

In the Money (ITM)

A Call strike price is In the Money anytime the underlying security trades above the strike price. This is not the same as “making money” on the Call.

At the Money (ATM)

At the Money refers to the strike price closest to the current trading price of the underlying security

Out of the Money (OTM)

A Call strike price is Out of the Money anytime the underlying security trades below the strike price.

Expiration

Although options have official expiration dates, consider the last trading day for the option as the critical time to exit open option positions.

Exercise

Exercising Call options refers to taking ownership of the actual underlying security (Fulfilling the terms of the contract). Call buyers have the right to exercise options. Options that are In the Money on the last trading session of their expiration will automatically be exercised by the broker if the holder did not sell to close out the option position

Buy to Open

The initial transaction to get into a Call option is considered opening the contract. If buying is the initial transaction, the trader is “Buying to Open” the contract.

Sell to Close

The second transaction, therefore, is considered closing the contract. Selling the contract (the second transaction) will close the trade – Selling to Close.

Buying a Call Contract Example

Let’s put it together in an example.

Pat believes the stock (underlying security) is going to rise higher over the next ten days. The stock is trading at $49.90 at the moment. Pat looks at options expiring in 38 days and considers the $50 Call strike price, which is considered At the Money because it is the strike price closest to the stock’s actual market price. The Ask price is $2.50 per share.

Pat puts in a limit order at $2.50 per share and is filled swiftly. Since each contract normally controls 100 shares of the stock, the cost is $250 ($2.50 x 100), not including broker fees. Pat has just Bought to Open an At-the-Money Call option for a $2.50 per share premium.

The security rises faster than Pat expected. In seven days, the stock has reached an exit target. Pat creates an order to sell the Call at its Bid price (premium) of $5.05 per share. The order is placed to sell at $5.05 Limit and is swiftly filled. Pat has Sold to Close a Call contract that is now In-the-Money because the stock is trading above the $50 strike price. Pat received $505, excluding broker fees. Pat calculated a gain of $255 ($505 proceeds minus $250 original investment equals $255 gains).

Pat bought a Call Option Contract to open, then, after the security climbed in value over a short period of time, Sold the Call Option Contract to Close and enjoyed a 102% return on investment ($505-$250 = $255 and $255/$250 = 102%) over seven days.

Call options can be a great way to leverage large or small trading accounts. The more you understand about Call options, the more confidence you’ll have in trading.

All the best,


Tom Gentile
America’s #1 Pattern Trader

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