With the volatility in the stock market last year during the COVID-19 pandemic, call options have surged in popularity as a way to leverage stock investments. You may have heard on Reddit about the $53,000 investment on GameStop by Keith Gill that turned into nearly $50 million on January 28, 2021. That was achieved using long call options.
A big advantage of using a long call option for your investment is leveraging up your investment but limiting your losses to what you put in. But you have to determine a strike price and expiration date. While you can use both short term and long term call options to leverage your investments, long term call options are less volatile than short term call options. This article is an introduction to using a long call option to leverage your investment.
A general warning: stock options are much more volatile than the underlying stocks. You can lose your entire investment very quickly, so you should only allocate capital that you’re willing to risk in its whole entirety to options.
What is a Stock Option?
Let’s take a look at how options work. A stock option is a contract giving you a right, but not the obligation, to buy or sell the underlying stock at a certain price and a certain time frame. A call option gives the right to buy a stock at a certain price for a certain time frame.
Using a Long Call Option to “Leverage Up” Stock investments
Here is an example using a call option– As of October 4, 2021, Apple stock is currently trading at $138.61 a share. A call option to buy Apple at the price of $150.00 a share expiring January 19, 2024 (about two years and 3 months from October 4, 2021) costs about $20.55 per share (one option contract is usually for 100 shares of the underlying stock – so one contract will cost you about $2,055). So using a somewhat extreme example let’s say hypothetically Apple sky rockets and reaches $277.00 a share by January 19, 2024. That’s about an 100% increase in the stock ($138.61 as of October 4, 2021), but each option you have now will be worth approximately $127.00 ($277 minus $150 strike price). That’s about a 5x return from buying the option. However, if the price of Apple is $150 or lower on January 19, 2024, you would lose your entire investment using options. It’s worth noting that options can be sold before the expiration date as well, so it can be sold any time between October 4, 2021 and January 19, 2024.
Looking at the Specifics
Let’s go into a bit more detail on the basics of buying an option. We’ll use the Apple call option example above. To buy an option, you will have to pay for the premium, or the cost to buy the option, which is about $20.55 per share, or $2,055 per contract as of October 4, 2021. The premium is mostly influenced by two choices you make when you buy an option:
- The strike price, the price where you can exercise an option to buy the underlying stock. In the example above, we used $150.00 a share as the strike price. For a call option, the higher the strike price is from the current price of the underlying stock, the lower the premium is.
- The expiration date – the duration in which your option is good for. The longer out the expiration date is from today, the higher the premium you have to pay for an option. The expiration date in our example above is January 19, 2024.
There you have it, those are the basics for stock options! Remember, while using a long call option can provide outstanding returns, it can also lose all of its value in a short time frame as well, so risk management is key when you use this derivative. Please see here a detailed guide on using LEAP options (options that expire a year or more out from the current date).
Disclaimer: The analysis presented is my opinion and does not constitute investment advice. I am not a financial advisor.