Updated: Apr 13
Welcome back to the Beginner’s Guide to Options Trading series. In case you missed it, check out this overview article where we covered the basics of options trading. In that article we discussed what an option is, the differences between call and put options, and buying versus selling options. This article is written for those who understand those basic concepts.
In the world of options, there are four primary ways to trade calls and puts
Buy Call Options
Sell Call Options
Buy Put Options
Sell Put Options
This picture shows what you would want the stock price to do for each scenario.
In this article we are going to dive into the details behind buying call options and will explain why you want the price to go up after you bought one. To illustrate the main points, we will walk through a call option example together.
Call Option Explained
The call option gives the buyer the right to buy 100 shares of stock at the strike price on or before the expiration date. The buyer can choose to execute this right at any point in time up to the close of the market on the expiration date. The seller is obligated to sell the shares at that time. The seller simply has no say in the matter.
Buying a Call Option Example
Indicates the stock symbol
All dates are expiration dates for the options contract.
Using the above photo of the SPY options chain, the call options are on the left side of the page. For the purposes of this article, pretend today is Jan 2, 2023. We pull up the option chain and decide to focus on the SPY 380 call option in the Jan 20, 2023 expiration. The current premium is $9.29 per share or $929 per options contract. The premium paid by the option buyer goes directly to the option seller immediately after the transaction is made.
In this transaction, one side will end up making money and the other side will lose money. It is paramount to understand the underlying motivation behind buying and selling call options to be a profitable options trader.
To communicate your purchase to another trader, you could say, “I bought the Jan 20, 2023 $380 SPY call for $9.29.”
How do Call Option Buyers Make Money?
Call option buyers make money when the stock goes up. As simple as this is, it is worth breaking this answer down and really dive in to see why this is true.
In this scenario pretend that you only have $10,000 in your account and do not own any shares or options. In fact, this will be your first ever trade! You decide to buy the SPY $380 call expiring on Jan 20, 2023 for a premium of $9.29. Buying this option gives you the right to buy SPY at the strike price of $380 at any point leading up to market close on the expiration date, Jan 20, 2023.
Fast forward to Jan 20, 2023 and at market open SPY is at $400. What do you want to do?
But first, how much do you think someone else would pay to buy SPY at $380 right now, when the current price is $400? Probably up to, but less than, $20.
Sometimes you just have to enjoy the cringy puns.
Now that you own the call option you have three choices to choose from:
You can exercise the terms of the call option and buy the shares
Close the position by selling the call option to someone else
Do nothing and continue to let time pass.
These three possible choices will be present for as long as you remain the owner of the call option. Let’s walk through each choice.
Exercising a Call Option
Exercising a call option means that you decide to buy 100 shares from the option seller. To exercise a call option, you have to notify your broker of your intent and they will do the rest. When everything is completed, you become the proud owner of 100 shares of stock. Of course, you have to pay for them at the agreed upon strike price. Although we are covering it first, this is my least common choice. In fact, at the time of writing this article, I’ve never exercised a call option.
After saying that, it is still worth walking through the example.
Using our example, when you exercise the call option, you buy 100 shares of SPY for $380, which would cost $38,000. The market price of SPY in this example is $400. This makes your 100 shares worth $40,000. Subtract out the cost of buying the option, $929, you would be looking at sweet $1,071 profit.
($400 Current Price - $380 Strike Price - $9.29 Premium Paid) = $1,071 unrealized profit
Keep in mind you will not lock in (or realize) your profit until you sell your shares.
Since the price of SPY changes with the ups and downs of the market, your profit (or loss) would follow suit. After all, you elected to buy 100 shares of SPY at $380 per share. When you consider the cost of the initial option purchase, the cost basis on your SPY position becomes $389.29 and your profit or loss equation is:
(SPY′ s Current Price - $389.29 Cost Basis)∗100 Shares = $Profit/Loss
Recall that we started out with only $10,000 in our account and do not have $38,000 to buy 100 shares. Fear not, we have other options!
Sell to Close the Call Option
Since you started out by buying the option, you close the position by selling it to someone else.
The call option you bought for $9.29 might be worth, as a guess, $19.29. By closing the position, you avoid the details of the previously outlined process and book a $1,000 profit! This tends to be the route many options investor choose since it does not require $38,000 to be in the account.
$19.29 premium received from the sale minus $9.29 purchase premium = $10 per contract. Each contract covers 100 shares. $10 per contract multiplied by 100 shares is $1,000.
With options, the market’s close on the options expiration date is the definitive end of the trade. If you choose to do nothing it comes down to the option being “in the money” or “out of the money” at expiration.
Example of a Call Option Expiring in the Money
You bought the $380 call option and SPY closes at $380.01 or higher on the expiration date. This means your option is “in the money” or ITM. A call that expires ITM will be executed and you will be assigned 100 shares for your call. Behind the scenes the broker automatically executed the call option on your behalf. You have to consider the premium you paid in terms of profitability. If you paid 9.29 for a 380 call this means SPY has to be over 389.30 for you to be profitable! See the explanation above on exercising an option. It is important to never forget that if an option expires ITM, SOMETHING will happen in your account.
Example of a Call Option Expiring out of the Money
In this example, we bought the $380 call option. If at the option's expiration the price is $379.99 or less, this would be considered an “out of the money” or OTM option. In this case the option would expire worthless and you would lose all of the premium you paid. You would also not be forced to buy any shares of SPY since you could buy them cheaper directly from the market.
If you bought a call option that ultimately expired OTM, you lost 100% of the premium paid at the beginning of the trade.
An option is an agreement between the buyer and the seller covering 100 shares of the stock. We specifically covered buying call options and how a call option becomes profitable when the stock price goes up. This is just the first article in GKT’s Beginner’s Guide series.
Buy Call Options – Check out GKT’s Beginner’s Guide to Buying Call Options
Sell Call Options – Check out GKT’s Beginner’s Guide to Selling Call Options
Buy Put Options – Check out GKT’s Beginner’s Guide to Buying Put Options
Sell Put Options – Check out GKT’s Beginner’s Guide to Selling Put Options
If you are eager to learn more, trading in a community of like minded people is far more fun, educational, and profitable! It is also the best place to rapidly expand your knowledge and comfort with trading options. Join our discord today: www.goodkidstrading.com/join