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Call Option Trading

Updated on October 19, 2009

Call Option Trading

There are several benefits to call option trading, primarily because of the leverage and limited risk that long call options afford. And when I say “long call options”, I’m referring to the act of buying call options, rather than selling or “writing” them, as it is known. Many people get confused with this terminology and they believe that if you’re buying a put option, you’re going short, but that’s actually not the case; even though a put option makes you money when the market goes down, you’re not in a short position in the markets, you’re in a long position, because you actually bought the option, and it cost you some out-of-pocket money to do so. If you were to actually sell or write the option, then you would be short, but any time money leaves your hands to enter into an option position, whether call or put, my friend, you are long. Again, let me emphasize that when you open a position with a call option and money has left your pocket to do so, you are long that call option. If you were to sell the call option, you would be considered short, because you have written the option that another person has purchased. Also, if you sell a call option with no other position to hedge that position, you have literally entered into a “naked” call option, meaning you have unlimited risk, because you haven’t protected your position with any type of spread situation. Okay, I’m starting to realize that my writing really has no structure to it at this point, and my thoughts about this stuff are a little unorganized, so let me start over, since I don’t feel like going back and editing all that stuff I just wrote. A call option is basically a contract that gives you the right, but not the obligation, to purchase a set quantity of either a stock or a commodity. For the sake of clarity (yeah, right, done a great job with that so far), I will use the stock market as an example. Call options in the stock market give you the right (but not the obligation) to buy 100 shares of stock at a specified price (called the “strike price”) before a specified date (because all options have an expiration date). Long story short, the practice of call option trading simply means that you’re not as concerned about actually buying the stock that the call option represents; you’re more focused on profiting from the fluctuations in value that happen with the actual call option itself.

Image courtesy of Microsoft Office Clip Art
Image courtesy of Microsoft Office Clip Art

Call Option Trading: The Importance of Volatility

So what do I mean by this? When you engage in call option trading, your main hope is that the market makes some type of dramatic upward swing. And let me emphasize the word “dramatic”, because it is always these sudden surges in a stock’s price that causes option premiums (or values) to rapidly rise. You see, an option is basically a bet on the future prospects of a stock. Since nobody knows the future, any move in a stock’s price in the here-and-now has a very significant effect on the value of a call option. I have seen it over & over again where you can buy a call option for only $100 or $200, and then some major spike happens in the price of the underlying stock, and the next thing you know, the price of the option goes surging upward, mainly due to the “magic word” that governs all option premiums: VOLATILITY. Volatility is basically a measure of how nervous the option writers are in the trading pits. When the price of a stock is wild and unpredictable, option writers raise their premiums, because the more volatile the stock’s price is, the more difficult it is to predict which way it’s going to go, therefore option writers will inflate the option premiums (or in simpler terms, prices) to compensate for the uncertainty of the market’s direction. If you think about it, your insurance policy works the same way. If you’re a good driver and stay on your best behavior and don’t get any tickets or get into any accidents, your premiums will stay much lower than a person who gets two speeding tickets a month and has a propensity for rear-ending people. Option premiums work the same way: The more unpredictable the stock’s price is, the more inflated the option premiums become. This is why, if you don’t remember anything else I’ve just written about call option trading, remember this: You always want to be buying call options when volatility is low, as long as there are some significant indicators that the price may rise in the near future. Once the price spikes up or shoots up sharply, you will more than likely see the value of your option rapidly increase, and even double or triple, and that will be the time to cash in your chips, exit your position, and take the money and run. I have a whole lot more to say about call option trading, and really just option trading in general, but I’ll save it for future hubs so that I won’t bore anyone to tears with a 20,000-word hub.

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