Buying calls is popular with options investors, novices and experts alike. The technique involves buying calls on a stock or other equity whose market price you think will be higher than the strike price plus the premium by the expiration date.
Alternatively, you buy a call whose premium you think will increase enough to outpace time decay. In either case, if your expectation is correct, you may be in a position to realise a positive return. If you’re wrong, you face the loss of your premium — generally much less than if you had purchased shares and they lost value.
Call buying may be appropriate for meeting a number of different objectives. For example, if you’d like to establish a price at which you’ll buy shares at some point in the future, you may buy call options on the stock without having to commit the full investment capital now. Or, you might use a buy low/sell high strategy, buying a call that you expect to rise and hoping to sell it after it increases in value. In that case, it’s key to pick a call that will react as you expect, since not all calls move significantly even when the underlying stock rises.
Some experienced investors may purchase calls in order to hedge against short sales of stock they’ve made. Investors who sell short hope to profit from a decrease in the stock’s price. If the shares increase in value instead, they can face heavy losses. Buying calls allows short sellers to protect themselves against the unexpected increase, and limit their potential risk.
Exercising your Calls
Most call contracts are sold before expiration, allowing their holders to realise a profit if there are gains in the premium. If you’ve purchased a call with the intent of owning the underlying instrument, however you can exercise your right at any time before expiration, subject to the exercise cut-off policies of your broker. However, if you don’t resell and don’t exercise before expiration, you’ll face the loss of all of the premium you paid. If your call is out-of-the-money at expiration, you most likely won’t exercise.
An Alternative to Margin
For certain investors, buying calls is an attractive alternative to buying stock on margin. Calls offer the same leverage that you can get from buying on margin, but you take on less potential risk. If you buy stock on margin, you must maintain a certain reserve of cash in your margin account to cover the possible loss in value of those stocks. If the stock price does fall, you must add cash to meet the margin requirement, liquidate a portion of your position, or face having your broker liquidate your assets. If you purchase calls, you have the same benefit of low initial investment as the margin trader, but if the value of the stock drops, the main risk you face is loss of the premium, an amount that’s usually much smaller than the initial margin requirement.
Calling for Leverage
One major appeal of purchasing calls is the possibility of leveraging your investment, and realising a much higher percentage return than if you made the equivalent stock transaction.
Source: The Options Industry Council otherwise known as OIC