Call Option Trading: From Basics to Covered Call Strategy

 Hello! Today, we will take an in-depth look at Call Option trading, one of the financial derivatives. A call option grants the 'right to buy' a specific underlying asset (stock, index, etc.) at a predetermined price (strike price) at a specific future point in time (expiration date). It is important to note that it is a 'right', not an 'obligation'.

In this article, we will explain in detail, with various examples, from the basic concepts of call option buying and selling strategies, to the covered call strategy widely used by many investors.

Call Option Buying (Long Call): Betting on a Bull Market

Concept: A call option buyer pays a premium (option price) to acquire the right to buy a specific underlying asset at the strike price on the expiration date.

Investment Motivation:

• Used when the underlying asset price is expected to rise significantly.
• Offers high leverage with a small cost (premium). (Can benefit from large price movements with less capital than direct stock purchase)

Profit/Loss Structure:

• Maximum Profit: Unlimited (Profit continues to grow as the underlying asset price rises)
• Maximum Loss: Premium paid (If the underlying asset price closes below the strike price, the option expires worthless, and the buyer loses the entire premium paid)
• Break-even Point (BEP): Strike Price + Premium

💡Example:

• Assume the current price of ABC stock is $50.
• Investor A expects ABC stock to rise significantly within the next month.
• Buys 1 contract of ABC call options (representing 100 shares) with a strike price of $52, 1-month expiry, and a premium of $2. Total investment cost is $2 * 100 = $200.

💡Results by Scenario:

If ABC stock price rises to $60 at expiry:

• Investor A exercises the right to buy the stock at $52 (cheaper than the market price of $60).
• Immediately sells it in the market at $60, earning a profit of $8 per share ($60 - $52).
• Total Profit = ($8 * 100 shares) - initial premium $200 = $800 - $200 = $600
• Option trading fees are separate.

If ABC stock price rises to $54 at expiry:

• Investor A exercises the right to buy the stock at $52.
• Immediately sells it in the market at $54, earning a profit of $2 per share ($54 - $52).
• Total Profit = ($2 * 100 shares) - initial premium $200 = $200 - $200 = $0 (Break-even point: $52 + $2 = $54)
• Option trading fees are separate.

If ABC stock price falls to $50 at expiry:

• Exercising the right is meaningless as the strike price ($52) is higher than the market price ($50).
• The option expires worthless.
• Maximum Loss = Premium paid $200

Key: Call option buying is advantageous when predicting a strong rise in the underlying asset, with limited loss and unlimited profit potential. However, it can become disadvantageous as expiry approaches due to time value decay (theta).

Call Option Selling (Short Call / Writing a Call): Expecting Limited Upside or Decline

Concept: A call option seller receives a premium in exchange for the 'obligation' to sell a specific underlying asset at the strike price on the expiration date if the option buyer exercises their right.

Investment Motivation:

• Used when the underlying asset price is expected to trade sideways or fall.
• Or used when the underlying asset price is not expected to rise significantly above the strike price.
• The primary purpose is to generate income by collecting premiums.

Profit/Loss Structure:

• Maximum Profit: Premium received (if the underlying asset price closes below the strike price and the option is not exercised)
• Maximum Loss: Unlimited (if the underlying asset price continues to rise, the seller's loss can theoretically be unlimited. Especially risky in the case of Naked Call Selling)
• Break-even Point (BEP): Strike Price + Premium

Two Types of Call Option Selling:

• Naked Call Selling: Selling call options without owning the underlying asset. Carries a high risk of significant losses if the stock price soars. Considered a very risky strategy.
• Covered Call Selling: Selling call options on an underlying asset that you already own. We will cover this in detail below.

💡Naked Call Selling Example:

• Assume the current price of XYZ stock is $100.
• Investor B expects XYZ stock not to rise significantly.
• Sells 1 contract of XYZ call options with a strike price of $105, 1-month expiry, and a premium of $3. Collects a premium of $3 * 100 = $300.

💡Results by Scenario:

1) If XYZ stock price closes at $102 at expiry:

• The option is not exercised as the strike price ($105) is higher than the market price ($102).
• Investor B earns the entire collected premium of $300 as profit.

2) If XYZ stock price rises to $110 at expiry:

• The option buyer exercises their right. Investor B incurs an obligation to buy the stock in the market at $110 and sell it to the option buyer at $105. (Or cash settlement)

Loss per share = $105 - $110 = -$5

• Total Loss = (-$5 * 100 shares) + initial premium $300 = -$500 + $300 = -$200

3) If XYZ stock price soars to $120 at expiry:

• The option buyer exercises their right.
• Loss per share = $105 - $120 = -$15
• Total Loss = (-$15 * 100 shares) + initial premium $300 = -$1500 + $300 = -$1200 (Loss continues to grow as the stock price rises)

Key: Naked call selling aims for limited profit but carries unlimited potential loss, so it should be approached with extreme caution.

In-depth Strategy: Covered Call

The covered call is one of the relatively conservative option strategies, used by many stock investors to generate additional income.

Concept: This strategy involves selling a call option on an underlying asset (at least 100 shares) that the investor already owns. The name 'Covered' means that even if the obligation to deliver the stock arises from selling the call option, that obligation can be fulfilled with the shares already held.

Investment Motivation:

• When you want to generate additional cash flow (premium income) from your existing stock holdings.
• When the price of the held stock is expected to not rise significantly or to fall slightly in the short term.
• To achieve the effect of slightly lowering the purchase price of the held stock (by the amount of the premium).

How it Works:

• The investor holds 100 shares of a specific stock.
• Sells 1 contract of a call option on that stock and receives a premium. Typically, an out-of-the-money (OTM) option with a strike price slightly higher than the current price is sold.

Profit/Loss Structure:

• Maximum Profit: (Strike Price - Stock Purchase Price) + Premium Received. Profit is capped at the strike price.
• Maximum Loss: Stock Purchase Price - Premium Received. (Theoretically, if the stock price drops to 0, it's a large loss, but much less risky than naked call selling.)
• Break-even Point (BEP): Stock Purchase Price - Premium Received

💡Covered Call Example:

• Investor C purchased and holds 100 shares of DEF stock at $45 per share.
• The current price of DEF stock is $50.
• Investor C expects DEF stock not to rise significantly above $55 in the short term and wants additional income from their holdings.
• Sells 1 contract of DEF call options with a strike price of $55, 1-month expiry, and a premium of $1.50. Collects a premium of $1.50 * 100 = $150.

💡Results by Scenario:

If DEF stock price closes at $53 at expiry:

• The option is not exercised as the strike price ($55) is higher than the market price ($53).
• Investor C keeps the stock and the collected premium.
• Total gain = ($53 - $45) * 100 shares (stock profit) + $150 (premium) = $800 + $150 = $950

If DEF stock price rises to $60 at expiry:

• The option buyer exercises their right. Investor C is obligated to sell their 100 shares of DEF stock at the strike price of $55.
• Total Profit = ($55 - $45) * 100 shares (profit from stock sale at strike) + $150 (premium) = $1000 + $150 = $1150
• Note: Without selling the covered call, if Investor C had simply held the stock, their profit would have been ($60 - $45) * 100 shares = $1500. By selling the covered call, Investor C gave up $350 of potential upside ($1500 - $1150).

If DEF stock price drops to $40 at expiry:

• The option is not exercised as the strike price ($55) is higher than the market price ($40).
• Investor C still owns the stock and keeps the $150 premium.
• Loss from stock holding = ($40 - $45) * 100 shares = -$500
• Total = -$500 (stock loss) + $150 (premium) = -$350 (The premium slightly cushioned the loss compared to just holding the stock, which would have been -$500)

Key point: Covered calls can generate steady extra income and slightly cushion downside but cap your profit if the stock surges.

Conclusion and Risk Management

Call option trading is an attractive investment method that allows for various strategies depending on the price direction of the underlying asset.

• Call Option Buying (Long Call): For strong upward expectations, with limited loss and unlimited profit potential (leverage).
• Call Option Selling (Naked): For sideways or downward expectations, with limited profit and unlimited loss potential (high risk).
• Call Option Selling (Covered Call): Utilizing held stocks, for sideways or moderate upward expectations, generating additional income and providing limited loss cushioning (profit capped).

Option trading is affected by the following factors, so always exercise caution:

• Time Decay (Theta): The time value of an option decreases as it approaches expiry. This is disadvantageous for option buyers and advantageous for sellers.
• Volatility (Vega): When the expected volatility (implied volatility) of the underlying asset's price increases, the option premium rises; when volatility decreases, it falls.
• Underlying Asset Price Fluctuation: This is the most crucial factor.

Option trading carries high risk as much as it has high profit potential. Before making investment decisions, you must acquire sufficient relevant knowledge and choose a strategy that aligns with your investment goals and risk tolerance. It is advisable to start with small amounts to gain experience, and continuously monitor market conditions.

Investment Disclaimer: The content of this blog is for informational purposes only and does not constitute a recommendation to buy or sell specific securities. The final decision and responsibility for all investments rest with the investor. Market conditions are unpredictable, and past data does not guarantee future returns. Thorough analysis and consultation with experts are recommended before making investment decisions.