Call Option

Stock Buying vs Call Option

One of the most common situations in investment practice is when an investor buys a call option instead of the underlying shares because he does not have enough available cash at that moment.

A speculative trader may do exactly the same thing, even though he has enough money to buy the underlying shares. His motivation is different—to gain control of the same number of shares while committing significantly less capital.

However, initially, both market participants are in exactly the same position and, therefore, assume the same level of risk.

Since the price of a call option represents only a small fraction of the cost of the underlying shares, purchasing a call option is a cost-efficient way to participate in a rising market without using high-risk margin loans (borrowing funds from a broker). At first glance, call options may therefore appear to be an attractive alternative to buying shares.

However, this is only true at first glance.

Personally, we do not consider buying a single call option to be a genuine trading strategy, despite the fact that many textbooks describe it as one. In our view, it is simply an aggressive bullish speculation, which in most cases is driven by the trader's inability or unwillingness to commit enough capital to purchase the underlying shares.

It is also important to remember that options are wasting assets. Unlike shares, they lose value over time. As expiration approaches, the value of an option gradually declines because the probability of a favorable price movement for the option holder becomes progressively smaller.

 

What Is a Call Option?

 

Before moving any further, it is important to understand the rights and obligations that a call option creates for each market participant. This is how most textbooks describe them:

A call option gives the buyer the right, but not the obligation, to purchase the underlying shares at a predetermined strike price within a specified period of time.

A call option provides the buyer with unlimited profit potential if the price of the underlying shares increases. Unlike a long stock position, however, the buyer's maximum risk is limited to the option premium paid.

For the seller of a call option, the situation is exactly the opposite. The seller assumes the obligation to sell the underlying shares at the predetermined strike price if the buyer decides to exercise the option during its lifetime.

A call option exposes the seller to unlimited loss potential if the price of the underlying shares rises, while the maximum possible profit is limited to the option premium received.

Depending on market conditions, an investor may open either a long call position (buy a call option) or a short call position (sell a call option).

Now let's examine how attractive each of these alternatives really is.

 

Buying a Call Option (Long Position)

 

Opening a long position means that the investor acquires the right to purchase the underlying shares at a predetermined strike price until the third Friday of the expiration month (for standard listed options).

The premium paid when opening a long call position represents the maximum possible risk for the option holder.

At the same time, the maximum profit is theoretically unlimited and depends entirely on how much the price of the underlying stock rises above the strike price.

As the stock price increases, the value of the long call position also increases because its owner has the right to buy the shares at a strike price that is lower than the current market price. (We will explain this mechanism in much greater detail in another article.)

This is why, during a bull market, so many investors and traders are interested in opening long call positions.

 

Selling a Call Option (Short Position)

 

In this section, we are referring to the sale of an uncovered ("naked") call option, where the investor sells a call option without owning the underlying shares. By doing so, the seller assumes the obligation to deliver the underlying shares at the predetermined strike price if the option is exercised before expiration or on the expiration date. In our opinion, this is one of the riskiest option positions and is generally used by traders who have a neutral or bearish outlook on the future direction of the market.

At this point, many beginners ask a perfectly reasonable question:

"But I don't own any shares. How can I sell a call option? What exactly will I have to deliver if things go wrong?"

Although this may seem like a simple question, the answer is not quite so straightforward. Nevertheless, we'll try to explain it.

“You do not need to own the shares in order to sell an uncovered call, but by selling the option you assume an obligation. If the option is exercised, you must deliver the underlying shares at the strike price. If you do not already own them, you may have to purchase them at the current market price”.

Textbooks describe the position as follows:

The option premium received when selling a call option represents the maximum possible profit from the position.

The maximum possible loss, however, is unlimited and depends on how far the price of the underlying stock rises above the strike price.

If the stock price moves above the strike price, there is a risk that the option buyer will decide to exercise the option. In that case, the seller is obligated to deliver the underlying shares in a quantity equal to the number of call options sold at the predetermined strike price.

The only amount that the seller keeps regardless of the outcome is the option premium received when opening the short position.

Legally, the seller of a call option is obligated to deliver the underlying shares if the option is exercised before expiration or on the expiration date (assignment). However, in practice, early assignment is relatively uncommon. Based on our own experience of more than 25 years of trading, we have encountered such situations only a few times.

In many cases, traders prefer to close their short positions by entering an offsetting transaction before expiration rather than allowing the option to be exercised. If assignment does occur, its consequences depend on the type of account, the broker's rules, and the terms of the particular option contract. Depending on these factors, the account may reflect a short stock position or another settlement outcome, which is often accompanied by a significant negative cash balance.

Once the resulting position has been closed, the cash balance is generally adjusted accordingly. The final financial result is determined by the combined outcome of all related transactions rather than by the assignment itself.

 

Initial margin & Margin call meaning

 

In reality, no brokerage firm will allow you to open a short position without posting margin, which will remain on your brokerage account until the position is closed.

The required initial margin can be substantial and may be many times larger than the premium received. The exact amount depends on regulatory requirements, the broker's house rules, the option's terms, the underlying stock, and the overall account risk.

If the stock continues to rise, your short call position begins to generate losses.

When losses on an uncovered short position reach the level at which the broker's margin requirements are no longer met, the broker may require you to deposit additional funds (a margin call). The time allowed to meet a margin call depends on the broker and the circumstances. A brokerage firm may require additional funds on very short notice and may liquidate positions without prior notice when permitted by the account agreement and applicable rules.

If the stock price does not fall by then, or if the required funds are not deposited, the broker has the right to close your position without your prior approval, in accordance with the terms of your margin agreement, using the funds from your original margin deposit.

Remember: the broker's margin rules are designed to protect the brokerage firm, not to protect your position from loss.

However, traders who speculate on falling prices usually enter these positions during stable or bear markets, because under such market conditions there is very little chance that the option will be exercised unless the market suddenly reverses to the upside.

That kind of reversal can become extremely expensive. For this reason, we do not recommend selling naked (uncovered) calls (uncovered call writing).

We suggest comparing both positions by identifying the advantages and disadvantages of each.

 

Figure 1. Comparison of a call option buyer (long call) and seller (short call).

 

 

As you can see from the table above, a short position has one obvious advantage — you don't have to pay any money upfront. On the contrary, you receive money when you open the position.

 For many traders, this single advantage outweighs all the disadvantages of a short position, often leading to very unfortunate consequences. There's no such thing as a free lunch.

 However, there are situations where you can still enjoy the reward without getting caught in the trap, by reducing your risk to a level that suits you.

 But that's a completely different story.

 

Frequently Asked Questions

 

Should I buy shares or a Call Option?

There is no universal answer—it depends on what you are trying to achieve. For most people, buying shares is generally the more appropriate choice for long-term investing. A Call Option may be more suitable if you expect the share price to rise over a shorter period. Buying shares gives you more time, while buying a Call Option provides greater leverage, but it also requires you to correctly anticipate not only the direction of the price movement, but also when that movement is likely to occur.

 

Can I buy and sell the same Call Option on the same stock with the same strike price and expiration?

No practical advantage. Buying and selling the same Call Option with the same strike price and expiration creates opposite positions that offset each other. As a result, you generally end up with no net position.

 

Can I use margin to buy a Call Option, just as I can when buying shares?

When buying a Call Option, you generally pay the entire option premium with your own funds. Unlike buying shares, brokers typically do not provide margin financing for long option positions.

 

 

The Story Continues...

Covered Call

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