There are two types of options – calls and puts. Let’s review calls first. A call gives you the right to buy an underlying asset at a certain price point in the future. Think of a house you’re considering buying, which currently costs $250,000. You don’t have money to buy at that price now, but you’ll be able to afford it in 6 months. So, you tell the seller you can purchase the home in 6 months at the current price and he agrees. Wouldn’t that be great!

This is essentially a Call Option. This strategy allows you to set a Strike Price, and exercise the right to buy underlying assets in the future at that price. You will also pay a premium to exercise this option. One call controls 100 shares and the price paid is the quoted price for the option, multiplied by 100.

In Figure 5, the x-axis shows the price of the underlying asset and y-axis is the profit/loss. The real value of the underlying asset, represented by the green line, is increasing as the price moves higher. The strike price is the value of the underlying asset at which we make the Call. In the case of our house- we called the value at $250,000 and this can be considered the break-even line. Even if the real value of that house continues to rise, we exercise the right to buy it at $250,000 at a date of our choosing. With stock market assets, you’ll often have many different strike prices to choose from when creating a contract so it is crucial to select the optimal price. Choosing the optimal expiration month is significant as well.

Figure 5- Long Call Risk Graph

Similar to an insurance policy, an options contract has a time duration. Insurance policies are usually bought for one year- after which it expires and has to be renewed. Similarly, options too have to be renewed after they expire. However, an option can also be closed or offset any time prior to expiration. The breakeven point is the point at which x- axis meets y-axis. It’s the point at which the price of the underlying asset meets profit/loss.

Call Attributes 

There are a number of attributes or terms related to call options. We’ll run through the most important terms here. Once you’re familiar with these fundamental parts of an options contract, the rest will be easier to understand.

1. Strike Price

As you can see in the profit loss graph in Figure 6, you will have a limited loss at $200 and potentially unlimited gains once the stock goes above the $40 level. So, it is very important to select strike prices using predictive analytics or technical analysis. As shown in the graph, as time goes by between now and 6 months, your profit will fluctuate in the same way the underlying asset price fluctuates.

Figure 6- Long Call Risk Graph

2. Expiration Month

Selecting the best Expiration Month is equally important as selecting an optimal Strike Price. Again, as you can see in Figure 6, the stock has to move from $40 to $50 by a specified time. If you are not correct on the time, you might not benefit from the upward movement of the underlying asset.

3. Premiums

You will need to be comfortable with the option price, or premium. Depending on how uncertainty is in the market may be having an affect on the underlying option will alter the premium. Options are derivatives, so the premium will rise when there is uncertainty in the market and fall when there is less uncertainty in the market. These concepts are covered in more detail in our chapters on Implied Volatility.

4. Assignment & Expiration

Assignment and Expiration are can sometimes result in losses. If you face Assignment on an option that you wrote or sold, especially if your contract is in-the-money, you might sustain substantial losses. Take caution and close your option contract prior to expiration or pay attention when the broker dealer assigns you on an option, which results in Short Stock (puts) or Long Stock (calls). Close the position as soon as possible in order to avoid losses. Expiration is also very important as this is where you might want to close the position because if you don’t, the option can move similar to shares as you move closer to expiration.

5. Moneyness

The concept of moneyness is also important to understand. An option is either In-The-Money, Out-of-The-Money or At-The-Money. ATM calls have strike prices equal to the stock price. ITM calls have strike prices below the current stock price. Options with strike prices above the current stock price are OTM.

Points to Remember 

• Time Range Selection: If the Stock does not move from $42 to $50 within the time you selected, your options will expire worthless. This is the same scenario of taking insurance on a house. If nothing happens to the house, which is actually a good thing, you will lose the premium you paid to the insurance company. Insurance companies are so profitable because most of the time nothing happens to the house and they are able to collect premium without having to pay anything.

• Directional Bias: In order to be a successful trader, you have to have Directional Bias. If you are buying a Call, you should have an Upward Directional Bias. You expect the stock to increase in value so that you can make money out of it, even though the exact extent of increase is unknown.

• Volatility: High Volatility means high uncertainty, which will typically means you pay high prices for options.

• Leverage: An average retail account in United States is $10,000. For such an account holder, it might be impossible to buy a stock like PriceLine that trade at $15,000. Options allow you to leverage capital and make such trades possible.

• Risk vs. Probability of Success: Keeping in mind these two aspects will make you a more experienced   and confident trader. The higher the Probability of Success, the higher will be the risk involved. Once you get more experienced, you will learn to trade so that you have higher a Probability of Success, while at the same time able to aggressively defend your positions when a stock or market goes against you.