Daily Gains Letter

Call Options: Why They Should Be Part of Your Go-To Investment Strategy

By for Daily Gains Letter |

Call optionThe stock market is showing that it will not be easy to move to new record-highs given the overhanging uncertainties around the world, stretching from our backyard over to the Middle East and on to China. The current market risk is high, but as I mentioned briefly in my previous commentary (see “How to Limit Risk and Profit from Momentum Stocks Like Netflix”), you can play the upside via a leveraged risk management strategy: call options.

Use of Call Options on the Rise—And for Good Reason

While the majority of professional and retail portfolios are composed of stock positions, the use of options—either call options (betting the underlying stock price will rise) or put options (betting on a stock’s downside move)—have been on a dramatic rise over the past decade.

But you don’t have to be a pro trader to benefit from the use of options. For the majority of beginner traders and investors, options are easy to initiate and generally are either call or put options. More experienced traders could use spreads, straddles, butterflies, and ratios, among other options; but if you’re a beginner, put and call options offer an easy and beneficial starting point.

Call options are ideal for managing the total risk to which you’re exposed because you know exactly what you could lose (known as the premium paid for the option). Conversely, when you buy stocks, you can lose a lot more, as the stock could theoretically fall to zero. Even worse, short sellers are exposed to unlimited losses as the stock price could rise unabated.

How Call Options Work

As part of a balanced approach to investing, the use of call options makes sense for some risk-seeking investors. You can even use call options as part of a covered call strategy, where you set a selling price for an underlying position in your portfolio. What this does is generate some premium income for you from writing the call option, while also allowing you to set a desirable selling price for your stock. Of course, in a stalling market like we have now, you can write covered call options to generate some premium income, knowing the stock will likely not be called away by the expiry, especially with short-term expiries.

When to Use Call Options

Call options are excellent if you want to play the upside potential of the stock market, but you’re also concerned about the downside vulnerability. Even if you are wrong and the stock market declines, your maximum exposure is limited to the premium paid.

Moreover, one of the major benefits of buying call options is the leverage. Simply put, you do not have to put forth the same capital required when you buy the underlying stock. One option contract translates into the right to buy 100 shares of the stock at a much lower cost.

To make money on your call option, the stock price has to close above the strike price by more than the premium paid by the expiry, which can range from a week to two years. If you bet right, your call option can return excellent profits at a much higher return than if you bought the underlying stock.

A great site for options is the Chicago Board Options Exchange (CBOE).

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