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If you’re reading this, you probably know that buying call options and selling them for a profit can be an excellent way to grow your portfolio. What you likely don’t know is how to go about it and the most crucial considerations to keep in mind throughout the buying process.
If so, don’t worry; I’ve got you covered.
In a nutshell, ordering/buying a call option involves the following steps:
- Figure out your objective.
- Set up a brokerage account.
- Choose an appropriate call option.
- Purchase the call.
The first step is actually the most important when you are going into call options. You need to know why you are buying the call before you ever place the order.
Knowing why you are buying the call will allow you to sell the call if what you are expecting doesn’t happen and salvage some of your investment.
Say for example you believe some great news will come out about a stock or sector within 2 weeks so you buy a call option that is 1 month from expiring. If that news doesn’t materialize within those two weeks you can then sell the call and salvage some of your initial investment.
If you don’t know why you are buying. The call you are much more likely to “hold and hope” which is never a good investment plan.
Read on for some more in-depth coverage of the above steps.
1.Figure Out Your Objective
Options traders’ objectives often fall under one of these three categories:
- Hedging. Some individuals use options to manage risk on existing stock positions.
- Income generation. Options can also be a way to generate income on stocks already owned by an investor or ones that they would like to own.
- Speculation. Lastly, options can be a great way to assume a speculative position in the market through leverage. Some investors even use these to establish a position that may potentially profit if the market remains neutral.
Understanding your objectives is crucial because, among other things, it’ll help you choose the correct brokerage account. For instance, you may be better off with a margin account if you’re looking to establish a speculative market position using leverage.
2.Set Up a Brokerage Account
The second step in buying a call option is setting up the correct account type. Generally, investors have two options when opening a brokerage account: a cash account or a margin account.
With a cash account, the investor is required to pay the full price for all securities they buy. In other words, you can’t buy securities worth more than the funds in your account.
That’s unlike a margin account, where you can buy securities worth more than the funds in your account by borrowing money from your broker to make up the difference.
As with any other lender-borrower arrangement, interest is typically charged on this loan. Also, there’s always collateral, typically the securities held in your portfolio.
While a margin account is usually recommended for options trading, you don’t necessarily need one to buy call options. You can do that with a cash account, too.
Which account to choose?
Let’s quickly compare the two account types to help you make the best choice.
Margin Account vs. Cash Account
Beyond letting investors borrow money against their portfolios’ holdings, the main reason a margin account is recommended for options trading is that it allows you to execute more advanced strategies than a cash account.
As such, this account type is often recommended for investors with the experience and know-how to formulate and execute advanced options trading strategies.
On the other hand, margin trading carries more risk than paying upfront. Leverage (AKA, using borrowed money to fund a trade) amplifies your potential gains by allowing you to take a more significant position.
However, the other not-so-appealing side of the coin is that leverage also amplifies your potential losses by a similar magnitude.
Generally, the more leverage you apply to your capital, the more risk you shoulder. So if you have a low-risk appetite, you might be better off with a cash account.
Of course, whether this factor alone is enough to sway you to a cash account will depend on how much you prioritize risk minimization.
Important: Understand that regardless of the account type you choose, you may be required to file an options application before being allowed to trade options. Typically, you’ll be required to provide information about your investing experience, risk appetite, and overall financial situation.
3.Choose a Call Option
With your account all set up, the next step is to choose the call option you’d like to order. The first selection criteria here is to identify the stock or index that you believe will go up. You’ll also need to verify that the stock/index in question has options because not all stocks do.
With these two criteria met, the next thing to think about is the strike price. You won’t always find a call at your desired strike price for an option because strike prices tend to come in five-dollar intervals for more expensive stocks or one-dollar intervals for cheaper stocks.
However this isn’t always the case.
For instance, if stock X is currently trading at around $30, its strike prices might be $20, $25, $30, $35, and $40. Sometimes, you’ll find that the available strike prices for such stock are $22.5 and $27.5, or even $26, $27, $28, $29 especially if it’s popular.
Another consideration to keep in mind when selecting a call option is the expiration date.
Again, you often won’t always get what you’re looking for. Instead, you may find the expiration date to be a month out or only available for certain weeks or months. You have to choose what expiration date works with your strategy based on when you think the stock or index will rise.
You also need to factor in the option’s liquidity so that you can sell it if need be. To determine whether an option is liquid enough, take a look at its trading volume.
The higher the volume trading on a call option, the more liquid it is.
Lastly, you want to choose a reasonably priced call option. The price of an option is determined by the strike price, the share price of the underlying stock, how much time is left until expiration, and the underlying stock’s volatility.
Usually, the first three factors (strike price, underlying stock’s share price, and expiration period) aren’t problematic; investors tend to agree on these.
The underlying stock’s volatility and the direction it’s expected to take is what often divides investors, making it arguably the biggest driver of option prices.
So if you want to determine whether the call option you’re eyeing is reasonably priced, its volatility should carry more weight on your evaluation criteria.
4.Purchase the Call
Once you’ve got an idea of the stock you’d like to buy a call option for, log into your brokerage account. Select that particular stock, and proceed to the options chain.
Also referred to as an options matrix or options series (depending on the platform you’re using), the options chain is essentially a list of all available options contracts for any given security.
It displays all listed calls and puts, as well as their strike prices, their expiration, and other volume and pricing info.
Identify the specific options contract you want to trade and select it. Doing this will open an options trade ticket that allows you to enter a buy to open order and buy a call option.
From this point on, all that remains is to make your preferred selections (i.e., order type, expiration month, no. of options, etc.) to finalize placing the order.
Learning how to buy calls opens up a whole new world of options trading. So when you master it, don’t stop at that. Keep scaling your way up to more advanced trading strategies such as straddles, spreads, and condors.
Best of luck.