With all the buzz this year about GameStop and gamma squeezes, you might have heard the term ‘call options’ going around. But what exactly are options? Should you start trading with them? And when it comes to options, what are your, well, options?
What is a call option?
A call option is a contract that gives investors an option to buy shares at a specific price at a later date. Call options are bought when investors are banking on a share price to rise, so they can profit from the difference in price.
For example, if you were to buy a call option for Netflix (NASDAQ:NFLX) stock at $500 per share (called the strike price) and think it will be going up to, say, $502, you’re buying a call option to profit from the speculative rise in price.
It’s all kind of like being at the casino. You don’t know for sure what’s going to happen to the stock, but you think it will perform well, so you place your bets—or in this case, your call option.
If this is all starting to sound a lot like the GameStop scenario, you’re on the money. In this situation, investors bought call options (and stocks) by the bucket load in an attempt to hedge the stock. But as it soared higher, the market makers (the ones that sold the options) had to buy more stock, resulting in a gamma squeeze.
What are my options with options?
The reason that investors are drawn to buying call options is that they can obviously make money from the stock going up in price. But before you go and start placing your bets, there are a few important caveats to know about.
Firstly, in order to buy a call option, investors have to pay a premium. If the investor loses money on their call option, they will also have to factor in the loss of the premium.
The next thing to know is that call options differ in price depending on whether they’re ‘in the money’ or ‘out of the money’. When a call option is ‘in the money’, it means the stock price is already in profit, and the call option will be more expensive. For example, if you bought a stock at a strike price of $35, but it’s currently trading at $37. A call option that is ‘out of the money’ will be trading at below the strike price and will be cheaper (but also riskier) to buy.
The other thing to keep in mind is that call options have expiration dates. Whether it’s weekly, monthly, or quarterly, in order to buy the shares and then sell them immediately to make a profit, investors will need to exercise their option before this expiry date. Call options are more expensive if they have a longer expiry window because investors will have a longer period to wait for the stock to be ‘in the money’, and vice versa with shorter expiry periods.
Just when you thought we were done explaining options, here we are with another option. Alongside a call option, there is also something called a put option. Unlike call options that allow buyers to buy options at a set price, put options lets buyers sell an option at a set price. If the share price drops, then the buyer profits because it gets to sell it at the higher price.
Are call options a good call?
Now that you know everything there is to know about options—and hopefully, you haven’t read the word options so many times it’s lost all meaning—there are a few different strategies out there to start trading.
Ranging from a ‘covered call’, to a ‘long call’, and a ‘short call’, there are many strategies you can use to win at the options game. If you’re ready to give it a go, look out for a brokerage firm to get started. Just know that there are usually about four or five different levels of trading that you will need to be approved before you can start trading.
There are many who have profited from trading call options, but, like all investing, there are also a lot of stories of people getting burned. But no matter which strategy you choose, even if some may seem less risky than others, trading using options, like all investing, comes with inherent risks.