Calls

Buying an In-the-Money Call

If you are bullish on a stock, you could choose to buy a call to take advantage of that move.  If you buy an in-the-money call, or a call whose strike price is below the price of the underlying stock, the value of the option will move up and down at roughly the same dollar amounts as the underlying stock. 

I say roughly because the amount the option moves is actually some fraction of the amount the stock moves, depending on how close the option is to at the money.  This fraction is called delta and it approaches 1 the further you go in the money.  So if an option has a delta value of 0.85, for every dollar that the stock goes up or down, the option will go up or down by 85 cents.

Since you pay just a fraction of the cost of the stock to buy an option, you can make large gains if the stock moves just a few dollars.  For example, imagine that you buy a call option with a strike price of $30 on a stock that currently costs $35, and you pay $7.00 for the call ($5.00 intrinsic value, $2.00 time value).  If the stock goes up to $40, it has increased in value by about 14%.  However, depending on how long the move took, the call could now be worth between $10-$12.  That gives you a gain of 42%-71%.

However, the reverse is also true.  If the stock were to go down to $30, you would have lost 14% if you were holding the stock.  With the call option, the most you stand to recover is any time value that is still left in the option.  It’s quite possible to lose 100% of the value of the option.

Buying an Out-of-the-Money Call

You can also choose to buy an out-of-the-money call option.  These options are much cheaper than the in-the-money calls.  However, this strategy carries a lot more risk because the option has no intrinsic value.  Therefore, the only way you can make money is if the stock increases in value enough past the strike price of the option to make up for the lost time value (assuming you hold the option until expiration).

For example, if you buy a call option with a strike price of $40 on a stock that is currently worth $35, it might cost you around $2.00 (depending on many factors such as how much time is left until expiration).  In order for this option to be profitable at expiration time, the stock must have risen to at least $42.  So a gain of 20% on the stock simply gets the option to break even.  If the stock were to increase beyond that, the option could go on to have much higher gains.  However, the most likely outcome is that the option will expire out of the money, or worthless.

Selling a Covered Call

If you a own a stock that you think is not going to increase in value, one way that you can still profit from it is to sell covered calls.  Remember that buying a call gives you the right to buy the underlying stock at the strike price of the call until its expiration date.  Conversely, the person selling the call has an obligation to sell the underlying stock at the strike price, if the option is exercised before its expiration date.  If the option is never exercised, it becomes worthless and seller keeps the premium that was paid for it as profit.

For example, if you own a stock that is worth $37 and you don’t think it is going to up in value, you could sell the $40 call option.  You would sell 1 contract for every 100 shares that you want to include in this trade.  If by the expiration date of the option, the stock is worth $40 or less, you get to keep the premium.  However, if the stock has risen above $40, you must either buy back the options at a loss, or simply sell your stock at $40.

Note that even if you get called out of your stock, you still make a profit.  You get both the premium that is paid for the call option, as well as the $3 gain on the stock - from $37 to $40.  Any gains above $40 go to the call owner, not you.

Selling a Naked Call

Selling a naked call is similar to selling a covered call, except that you don’t own the underlying stock.  That makes this type of trade very risky.  Consider the previous example where you sell a $40 call option on a stock that is currently worth $37.  If the stock were to skyrocket to $100 before expiration, you would be forced to buy the stock in the market for $100 in order to fulfill your obligation of selling the stock to the call owner at $40.