CHAPTER
8

Call Strategies

In This Chapter

• How call options work
• Potential payoffs
• Using calls to speculate
• Hedging with call options

Calls are options that give you the right—but not the obligation—to buy something in the future at a price agreed upon today. You can exercise that right at any point until the option expires. Calls are bets that the price of the underlying asset will be higher than the strike price by the time the expiration rolls around. That’s why calls are often considered to be a bullish derivative.

At the most basic level, people buy calls as bets that the underlying will increase in price. They are hoping that the call will allow them to buy the underlying asset at a price below the market.

Traders use calls in many ways, from the simple to the complex. This chapter covers many of their uses. Not all of these calls will be appropriate for you. However, learning more about calls might help you better understand a simple strategy.

Basic Uses of Calls

A call is an option that gives you the right to buy a share of stock at a specified price in the future. If you buy a call option, your payoff looks like the following graph:

A is the strike price.

The vertical axis is the amount of profit you receive, and the horizontal axis is the price of the underlying asset. The line drawn at zero profit is the x axis and is the price of the underlying asset. Showing it helps illustrate when the option is profitable and when it is unprofitable to the holder. Until the option is exercised, the position is at a loss equal to the premium.

For example, let’s say you buy a American-style March 2017 call with a strike price of $120 on an stock with an underlying price of $106. You pay $1.08 for the call. Although you can exercise the option at any time, you probably won’t do so until the price of the underlying asset is above $120 because you can buy the stock cheaper in the open market. Below $120, you lose the $1.08 cost of the call. Above a stock price of $121.08 (or the strike price plus the call premium), your position is profitable. At stock prices between $120.00 and $121.08, exercising the option will reduce the loss. If you exercise when the market is at $120.50, you’ll have a profit on the stock of the $120.50 market price less the $120.00 strike price, or $0.50. That $0.50 offsets some of the $1.08 premium, for a total cost of $0.58.

With a long call position, you are out the amount of the premium. Part of that loss might be offset by an increase in the value of the underlying asset. Your position is considered to be in-the-money if the underlying is above the exercise price. However, it is only profitable to exercise when the underlying asset hits a price above the sum of the strike price plus the call premium.

Still, it is worthwhile to exercise the call option whenever it is in-the-money because exercising the option will reduce your loss.

If you write a call—also known as the sale of a call, or being short a call—you receive the premium. In exchange, you agree to sell the stock at the strike price, should the buyer choose to exercise the option.

Here’s what the payoff from the short call position looks like:

A is the strike price.

As with the call payoff graph, the vertical axis is the amount of profit you receive, and the horizontal axis is the price of the underlying asset. The line drawn at zero profit helps illustrate when the short call becomes is unprofitable to the writer. The writer keeps the premium no matter what happens to the underlying. The writer must transfer the underlying asset if the call holder decides to exercise it. This will most likely happen if the call is in-the-money. However, holders are free to exercise at any level of moneyness they choose.

For example, suppose you write an American-style call option on a common stock that has a current price of $32.50 per share. This option expires in a year and has a strike price of $40. The premium is $0.48. And you, dear writer, get to keep that $0.48 no matter what happens. The trader who buys the option from you won’t be in-the-money until the stock price is above $40. (Of course, people exercise options for different reasons, and you could hit it lucky and be assigned to receive $40 per share for a stock with a market price of $35.00. Cha ching! Don’t count on that, though.) If the market price is $41 when the option is assigned, you must deliver the stock to the option holder. At a market price of $41 and a strike price of $40, you’ll have a loss of $1. Of course, you also have the $0.48 premium, so your total loss is $1.00 – $0.48 = $0.52.

With a short call position, you keep the amount of the premium, no matter what happens to the strike price. The position is considered to be in-the-money at prices below the exercise price.

The following table summarizes the economics of a call option for both the buyer and seller.

The buyer of a call pays a premium and will receive the underlying asset at exercise. The option is profitable to exercise if it is in-the-money—meaning that the underlying price is higher than the exercise price. The most the buyer can lose is the premium paid. The most the buyer can make is the market price of the underlying asset, less the strike price, less the premium paid. Call buyers are generally bullish.

Call writers have a different set of economics. They receive the premium in exchange for writing the option. If the option is exercised, the writer has to transfer the underlying asset to the option holder. If the option is not exercised, the writer’s profit is the premium amount. If the option is exercised, the writer’s loss is the difference between the market price and the strike price, offset by the premium. (Note that the writer’s cost might be different than the market cost of the underlying. Many option sellers write options on stocks they already own.) Option writers have a more bearish view of the market than option buyers.

Why Use Long Calls

Let’s start with the simple proposition of buying a call. You are taking a position on the underlying asset increasing in value. Why?

Hedging with Long Calls

It might seem strange to want insurance against the price of the underlying asset going up, but that is exactly what people want when they hedge with long calls. There are situations in which an increase in the price of the underlying asset is a problem:

• Being short the underlying stock
• Needing to pay bills in a different currency
• Running a business in which profits will be hurt by rising energy prices

Being Short a Call

The person who writes the call is short, meaning that he hopes the underlying asset stays flat or goes down. Short calls have many uses in trading.

Hedging with Short Calls

The value of a short call as a hedge comes from the income generated on a covered position. If you write a call on an asset you already own, you will make some money if it falls in price or stays flat. That gain is offset by the loss of the asset should the option be exercised. Some stock holders use a call as a way to sell an appreciated stock. They use the premium to offset the capital gains tax obligation.

Short calls don’t really offer price protection, but they are a way to make money if the market is flat or down. Short calls might be part of complex hedging strategies because the premium income might offset the cost of purchasing other derivatives used to build the hedge.

Speculating with Short Calls

Short-call speculation strategies are tied to income. The option writer receives the premium and hopes to avoid exercising the option in question. The bet is that the price of the underlying asset will be below the strike price at expiration.

A covered-call strategy involves writing options that are out-of-the-money on assets already owned.

Some covered-call strategies are written in-the-money, with the intention of having the underlying asset called away. This strategy offsets the transaction cost and capital gain on an asset sale.

Naked-call writing has more risk than covered-call writing. Writing naked calls is covered later in this chapter.

The Call and Its Premium

As with any option, the value of a call is affected by a variety of factors. The following table summarizes how the value of long and short call positions change as different market factors increase. The option price will be the same, but its relative value will be different to the holder and the writer.

Market Factor	Long Call	Short Call
Underlying Price	Increases	Decreases
Exercise Price	Decreases	Increases
Volatility	Increases	Decreases
Time to Expiration	Increases	Decreases
Interest Rate	Increases	Decreases
American Option	Increases	Decreases
Dividend	Decreases	Increases

This is related to the Black-Scholes model discussed in Chapter 5. If you compare, you’ll see that the value of the short call is similar to the value of the long put. The two have similar payoffs.

If the value of the underlying asset increases, the value of the long call increases, too. The short call becomes less valuable, all else being equal. The relationship to the exercise price is the opposite. For the long call, a high exercise price will be less valuable, but it will be more valuable for the call writer.

The big difference between the valuation of the short call and the long put are the factors that increase the likelihood the option is exercised. The person taking the long side of the option probably wants to exercise it, while the person on the short side would like to keep the premium and not be assigned. The greater the volatility and the more time to expiration, the more valuable the option is to the holder. Likewise, if volatility is low, the option has less value for the holder.

American options, which can be exercised at any time before expiration, are more valuable for the holder because the option could be in-the-money for a short period before expiration. The writer, on the other hand, would prefer a European-style option because, all else being equal, it is less likely to be assigned.

This background can help you think about the risk and return of the position that you are considering.

Call Strategies

Calls are traded on a standalone basis, but they are also used as part of different strategies. Some are simple, some are more complex. Following is the rundown.

Writing Covered Calls

A covered call is a call option written on an underlying asset. This is also known as a buy-write strategy. It’s a way to generate income with relatively little risk. Because you already own the underlying asset, you won’t lose much money if you have to sell it to the option buyer. If it’s an asset that you are already thinking of removing from your portfolio, the premium from the call option will help cover the transactions costs when it is called away.

The profit payoff for a covered call is the same as that of a short-call position. The difference is that the cash loss is smaller because you own the asset in question.

This strategy is popular in a neutral market. It also has the potential to perform well. The CBOE publishes the S&P 500 BuyWrite Index, which looks at a hypothetical trade involving the purchase of the S&P 500 Index and then writing calls on the index—a covered-call strategy on the entire market. Over the years, the BuyWrite Index has outperformed the S&P 500, but with less risk.

Writing Naked Calls

This is the practice of writing a call option on an underlying asset that you do not own. Because you are not covered, you’re naked.

The writer keeps the premium as long as the option is out-of-the-money. If the option is assigned (most likely because it is in-the-money), then the writer must buy the underlying asset in order to sell it to the option holder. This is an expensive proposition if the market is moving fast.

There is demand for deep out-of-the-money options that meet the needs of people pursuing complex portfolio hedging strategies. These also have low premiums. The problem is the premium generated will rise the closer the option is to being in-the-money. However, that also increases the risk.

Replacement Therapy

Replacement therapy is a strategy that involves selling a stock and replacing it with long calls to get your capital out of the market. The calls may be in-the-money or out-of-the-money, depending on how anxious the shareholder is to sell. This allows you to get out of a stock position while still retaining some upside potential.

Call Spreads

Call spread strategies involve the purchase of one call and the sale of another. The two differ on only one feature, such as strike price or expiration.

Call spreads also add an element of complication to a position. Instead of having to track an option and an underlying asset, you now must track two options. These aren’t beginner strategies.

Bull-Call Spread

A bull-call spread means you purchase a call with one strike price and then write a call with a higher strike price. The premium received will be less than the premium paid because the call with the higher strike price will be further out-of-the-money. This position has limited risk, but that comes with limited profit. (This is not necessarily a bad thing.)

For example, suppose you buy a June call on a stock with a strike price of $140 and a premium of $0.87. You then write a call with a strike price of $145 and a premium of $0.58. Your cost of the position is $0.87 – $0.58 = $0.29, and that’s the most you can lose.

The option you wrote will be in-the-money if the stock price goes above $145. The option that you bought will be in-the-money then, too. So you could exercise your option to buy the stock at $140, then sell it to the call holder at $145, for a net profit of $5.00. Of course, you have to take out the $0.29 cost of the position, for a maximum profit of $5.00 – $0.29 = $4.71.

The following graph shows the payoff:

A is the strike price of the long call and B is the strike of the short call.

The profit is limited to the difference in the strike prices less the difference in the premiums (also known as net debit or net premium paid). The loss is limited to the difference in the premiums. These are used by traders who are bullish, but not so bullish that they want to take a risk on the downside.

Bear-Call Spread

A bear-call spread involves buying a call with one strike price, and then selling a call with a lower strike price.

Suppose you buy a September call with a strike price of $39 for $0.15. You then write a September call with a strike price of $32 for $1.27. You now have a net credit position of $1.27 – $0.15 = $1.12. Now, your overall position is out-of-the-money and profitable to you as long as the underlying price is below $32. At that price, the option is likely to be exercised. You would have to buy the underlying asset in order to cover the assignment, so your loss would be the market price less $32. However, if the underlying price were at $39 or above, you could exercise your long call to limit your loss. Hence, your maximum loss would be $39.00 – $32.00 – $1.12 = $5.88.

The payoff looks like this:

A is the strike price of the short call, and B is the strike of the long call.

The maximum payoff is the difference between the premium received and the premium paid (the net credit position). The maximum loss is the difference between the strike prices minus the difference between the underlying premiums. This is a mildly bearish strategy. It is profitable when the underlying price is below the strike price on the short call on the expiration date, but its losses are limited.

Married Calls

A married-call strategy is similar to a bull spread except that the trade involves shorting the underlying asset while purchasing calls to cover the amount of the asset. The calls act as insurance against the short position moving against the trader. Married calls can be used to repurchase the asset and to close out the short, which is a fine insurance policy.

The following table is a summary of the costs and payoffs of call spread strategies.

Economics of Call Spread Strategies

Calendar Spread

A calendar spread, also called a time spread or a horizontal spread, involves buying a call with one expiration date and selling a call on the same underlying asset with the same strike price but a different expiration. This is a play on the time value and volatility of the options, because the value of the underlying asset nets out.

For example, you could buy a call with a strike price of $80 and an April expiration for $0.10. Then, you could write a call with a strike price of $80 and a July expiration for $0.60. You now have a profitable net credit position of $0.60 – $0.10 = $0.50.

However, you still have to make a decision about how to handle the underlying asset. The call you wrote for the July expiration could be exercised and assigned to you at any point up to and including the expiration date. You could minimize the risk by exercising your long call for $80 to keep on hand if the short call is exercised. However, if the price is below $80 when the July call expires, you have taken a loss on the asset position. A calendar spread is a speculative position that is usually closed out before the expiration date of either option.

Butterfly Spreads

Butterfly spreads get their name for the wings that form on the payoff graph, which you can see later in this chapter. Butterfly spreads are designed to play on expectations about volatility. Keep in mind that these are speculative positions, so they can do a lot of damage to your account. Also, the more transactions you make to establish a position, the higher the commissions and fees, which can wipe out profits no matter what happens to the price of the underlying asset. These strategies are for advanced traders only.

For example, let’s say that September calls are $8.50 for a strike price of $47, $5.80 for a strike of $52.50, and $3.15 for a strike of $3.15. First, you set up a bull-call spread, buying the option with the $47 strike and writing the option with the $52.50 strike. Then, you set up a bear-call spread, writing the $52.50 strike and buying the $57.50 strike.

The following table shows what your position looks like.

Long-Butterfly-Call Spread

	Strike	Premium
Bull-Call Spread
Buy	$47	($8.50)
Write	$52.50	$5.80
Bear-Call Spread
Write	$52.50	$5.80
Buy	$57.50	($3.15)
Net credit		($0.05)

Now, if the underlying asset trades above $57.50, then all of the options will be exercised. You’ll be able to buy shares at both $47 and $57.50, and then sell them to the traders who bought your calls at $52.50. In this situation, your profit will be $52.50 + $52.50 – $47.00 – $57.50 = $0.50, less the $0.05 cost of the premium, for a net profit of $0.45.

If none of the options are exercised, you’ve lost $0.05.

The following diagram shows the payoff:

A and C are the strike prices of the long calls, and B is the strike price of the short call.

The profit on a long-butterfly-call spread is equal to the difference in strike prices minus the difference in premiums. The loss is limited to the net premium paid. A long-butterfly-call allows a trader to profit when the underlying asset is not expected to change much in price, but with much less downside risk than either a straddle or a strangle (covered in Chapter 10).

Short-Butterfly-Call Spread

Just like the long-butterfly-call spread, a short-butterfly-call spread is the combination of a bear-call spread and a bull-call spread. However, the short-butterfly-call spread has different price points for the long and the short. A trader sets it up by buying two calls, either at the money (i.e., with a strike price that is the same as the current market price of the underlying asset) or out-of-the-money. The trader then sells one in-the-money call and one out-of-the-money call on the same underlying asset with the same expiration date. The two long calls have the same strike price.

Here’s an example. Let’s say that February calls are $12.35 for a strike price of $155, $5.57 for a strike of $165, and $1.82 for a strike of $175. First, you set up a bear-call spread, writing the option with the $155 strike and buying the option with the $165 strike. Then, you set up a bull call spread, buying the $165 strike and writing the $175 strike.

The following table shows what your position looks like.

Short-Butterfly-Call Spread

	Strike	Premium
Bear-Call Spread
Write	$155	$12.35
Buy	$165	($5.37)
Bull-Call Spread
Buy	$165	($5.37)
Write	$175	$1.82
Net credit		$3.43

If the underlying asset trade is above $155, you can keep the $3.43 credit.

If the asset trades above $175, all the options will be exercised, and the strike prices net out. The assignment of the call option written at $155 can be filled with the call option purchased at $165, for a loss of $10. The call option written at $175 can be filled with the second call purchased at $165, for a gain of $10. The underlying value nets out and you can keep the $3.43.

Between $155 and $175, this position will lose money. The amount you lose depends on the price of the underlying asset. If the price of the underlying asset is at $160, the option written at $155 is in-the-money. Your position is down $5, offset by the $3.43 credit, for a net debit of $1.57. The maximum loss occurs at $165 exactly, with the option position down $10 but offset by the $3.43 for a net loss of $6.57. As the underlying increases beyond $165, the gain on the bull spread offsets the loss on the bear spread.

The following diagram shows what the payoff looks like:

The figure crosses the x axis at the strike prices of the short calls. It loses the most at the strike price of the long calls.

The potential profit on this transaction is limited to the net premium paid. The potential loss is equal to the difference in strike prices minus the difference in premiums. A short butterfly allows a trader to profit from volatility, but with much less downside risk than either a straddle or a strangle (covered in Chapter 10).

Keep in mind that premium prices change frequently, so it might be difficult to set up a profitable butterfly. Also, you will probably want to close it out before maturity.

Economics of Butterfly-Call Strategies

	Long Spread	Short Spread
To establish	Net premiums	Net premiums
In-the-money	Difference between underlying, strike, and net premium	Net premium
Out-of-the-money	Lose net premium	Lose difference between the price of the underlying asset, strike, and net premium
Upside potential	Difference between underlying, strike, and net premium	Net premium
Downside potential	Net premium	Lose difference between the price of the underlying asset, strike, and net premium
Market view	Neutral	Volatile

Condors

Condors are like butterflies except that they have a spread on the strike prices. This gives them a wider wingspan than the butterfly (hence the name).

Long-Condor-Call Spread

A long-condor-call spread is similar to a long-butterfly-call spread, but with a wider range of prices where the position is at peak profitability. A trader sets it up by selling two out-of-the-money calls with different strike prices. She then buys one in-the-money call and one out-of-the-money call on the same underlying asset with the same expiration date, making sure that those strike prices are above and below the prices of the short calls.

The profit on a long-condor-call spread is equal to the difference in strike prices minus the difference in premiums. The loss is limited to the net premium paid. A long-condor-call allows a trader to profit when the underlying asset is not expected to change much in price. However, long-condor-calls have much less downside risk than either a straddle or a strangle and more flexibility than a butterfly.

A and D are the strike prices on the long calls, and B and C are the strikes on the short calls.

The strike prices on the short calls are above the x axis, and the strike prices on the long calls are below it.

The potential profit on this transaction is limited the net premium paid. The potential loss is equal to the difference in strike prices minus the difference in premiums. A short condor allows a trader to profit from extremes in volatility, but with much less downside risk than either a straddle or a strangle (covered in Chapter 10).

How to Think About Calls

Calls are generally thought of in conjunction with bullish strategies, but they can be used as part of bearish and neutral positions, too.

The key is to think about calls as tools, rather than something particularly bullish or bearish. A long call gives you the right to buy at a particular price. A short call gives you the obligation to sell at a particular price. A long call generates some income, and a short call costs money. Understanding those basics are far more important than mastering payoff diagrams.