Options Trading Basics And Call Option Strategies

There are 2 option types: (1) call option (2) put option. You can buy or sell either option type, then depending upon what you do will then determine the different rights or obligations that you have. Here is some of the basic option terminology that is necessary for understanding these rights and obligations, as well as the risk and reward to an options trade.

Underlying: This is what the option contract is based on, for instance a stock or etf, which would be the most common.

Exercise: This refers to invoking the right that is inherent in the option contract. For instance, the buying of a call buys the underlying when they exercise, and the buyer of a put sells the underlying when they exercise

Assignment: This refers to when an option buyer has exercised their option, and the seller is obligated to sell them the underlying in the case of a call, or buy the underlying from them in the case of a put.

Strike Price: This is the price where an option buyer can exercise the option.

Expiration Date: This is the date when the option contract becomes void. Technically it is the Saturday after the third Friday of the expiration month, but practically it is that Friday while the market is open. This is something to absolutely discuss with your broker, and be sure that you know their expiration instruction rules.

Multiplier: 1 option ‘represents’ 100 shares of the option. So, if you buy 1 call and exercise it, then you will be buying 100 shares. Also, if you buy 1 call for $1.00, then you will be spending $100 on your purchase.

(1) A call gives the buyer the right to buy the underlying at the strike price until expiration; they are not obligated to do so.  The seller of a call has the obligation to sell the underlying to the option buyer, if they exercise their right. 

(2) A put gives the buyer the right to sell the underlying at the strike price until expiration; they are not obligated to do so.  The seller of a put has the obligation to buy the underlying from the option buyer, if they exercise their right.

Note:  when you buy an option you are said to be long, and when you sell an option you are said to be short.  This can be confusing when you associate these terms to a stock and being long or short, because although you may buy a call when you want the underlying to go up, you may buy a put when you want the underlying to go down.

These graphs show the risk-reward to a call based on whether you buy it or sell it, and also note that you can combine a call buy and call sell into one trade and get a different risk-reward. When you have done this your position is called a spread; you can have a long spread or short spread.

I am going to show you a series of profit graphs for calls and puts, and the various trades that can be done. These graphs show what is called math to expiration, meaning what your option profit or loss would be if it was held until expiration day.

When you buy a call you have limited risk and unlimited gain. This profit graph shows buying 1 call at a 25 strike price for $2.00. You can see that your risk is limited to $200, or what you paid for the call, and that your gain goes up $100 for each 1 point increase in the underlying price above 27.00, which is your break even point. This is calculated simply by adding the cost of the option to the strike price = 25 + 2.00.

When you sell a call you have limited gain and unlimited risk.  This profit graph shows selling 1 call at a 25 strike price for $2.00.  You can see that your gain is limited to $200, or what you sold the option for, and that your risk goes up for each 1 point increase in the underlying price above 27.00, which is your breakeven point.  This is calculated simply by adding what you sold the option for to the strike price = 25 +2.00.

When you buy a long call spread, you buy 1 lower strike call and sell 1 higher strike call. By doing this you have limited risk like the long call, but you have further reduced the size of that risk. However, you have all gone from having unlimited gain to limited gain.

Why would someone do this strategy? Let’s say xyz has been in a range from 24 to 29.60 for the last few weeks, and has just sold off to 24.20. So, you now want to buy a call spread to get a bounce back to the 29.60 area, instead of having unlimited gain above a point you don’t think the stock will reach.

When you look at this profit graph, you can see that your maximum risk is $100 or what you paid for the spread, and your maximum gain is $400, which will be achieved if the underlying goes to 30.00 or higher at expiration. If the underlying goes to 29.60, and your target price, then you will make $360 = 29.60 – 25 strike - $100 position cost.

When you sell a short call spread, you sell 1 lower strike call and buy1 higher strike.  By doing this you have limited gain like the short call, but now you have limited risk instead of unlimited risk.

Why would someone do this strategy? There are a number of strategies developed for selling options for income, and selling call spreads would be one of them. 

The plan would be similar to that of the long call spread, where you identify the range for a stock, and then sell a call spread that is above the range.  For instance, xyz has been in a range from 17 to 22.80 for the last few weeks, and has just move up to 22.60.  So, you now want to sell a call spread above the range, where you don’t care whether the stock goes back down, you just don’t want it to go higher.

I can’t say that I really like the idea of risking $400 to make $100, but this kind of risk-reward ratio is typical, and part of the strategy.  If the stock is at the top of its range, with an anticipated move to sell back to the bottom of the range, buying a put or put spread would give similar risk reward to what was shown above for the long call and long call spread.

When you look at this profit graph, you can see that your maximum gain is $100, which you will get providing the stock remains below the short strike.  You can see that you will lose money above 26, which is your breakeven = 25 short strike + $100 spread sell price – this is also called a credit, which makes short spreads known as credit spreads.  Your maximum loss comes at 30, or the long strike in the spread.

Here is another strategy that is very common and that involves selling calls, it is called a covered call, or a buy-write – note that when you sell an option, you are said to be writing an option and you are an option writer.

What this strategy entails, is buying the underlying and selling a call at a strike higher than the price that you paid. For instance, buy 100 xyz at 23.00 and sell 1 25 call for 2.00, and you will have done a buy-write or covered call.

When you look at the profit graph and first compare it to that of the call sell, you will note that as the market goes up you do not get a 1:1 loss with the underlying. That is what is meant buy a covered call, because in the event that your call is assigned and you have to sell the underlying to the call buyer, you already own the underlying to give to them.

Instead you will note that as the underlying goes down that you will incur a 1:1 loss below your break even point, that is a function of owning the underlying and it being able to go down to zero –vs- if you had been long the call instead, you would have had a limited loss but unlimited gain.

Your break even point is 21.00 = 23.00 underlying cost – 2.00 for the short call. Your maximum gain is $400, which occurs at 25 or the short call strike. At that point you will make $200 on the underlying even though it is called away, and you will make $200 on the short call.

Why would someone do this strategy? You are buying a range bound stock that you believe has support in the $21.00 area and resistance in the $25.00 area, so the call sell covers the loss back to support, and resistance is in the area of your maximum gain. What the buy-write trader really wants to have happen is to buy the stock and have it expire below 25.00, where not only do they get to keep the proceeds from the call sell, they also get to keep the stock and then sell another call for the next expiration.