Call options can be a complex investing strategy and can be risky if you don’t know what you are doing.
Why are call options risky? The world of options is complex and often confusing to people who aren’t familiar with how they work. Options can have risk that is limited or infinite depending on which type it is. Here is a little more detail on calls and the risks that they could pose to you as an investor.
Call Options Defined
Options come in two varieties. Calls and Puts. We are focusing on calls in this article, so we will start by defining what a call is.
The most basic definition of a call option is that it is a contract that gives the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time period.
Options can get extremely complex and are often used together as part of larger strategies. Sometimes for income, sometimes for speculation, or for tax purposes.
Types of Call Options
Call options come in different varieties and can either be bought or sold.
When you buy a call option you have the right to purchase the underlying asset at a specified price on or before a forthcoming date.
When you sell a call, you are betting that the underlying security will fall in price. This is a bearish strategy often executed in the equity markets.
A covered call is an options strategy that is covered by a long position in the underlying asset. This strategy provides downside protection on the stock while generating income for the investor.
You the seller will be paid by the buyer of your call option in the form of the option premium. If the buyer chooses to exercise their option, then your shares are “called” away. You are obligated to sell your shares of your security to fulfill the options contract. Your risk is essentially limited to having to sell your shares at a predetermined price.
On the other hand, a naked call option is a strategy where you sell a call option without owning the underlying asset. Your risk in this scenario is unlimited if you are forced to buy a security at a high price to meet the obligation of the options contract.
Because of this risk many brokerage firms will place strict limits on who can write options contracts. Often you will be required to show proof of assets.
Wrapping Up
This is an overly simplistic definition of the options market, but you can see where the risk can be with these investment instruments. Why are call options risky? Essentially, depending on which type of call you are talking about, there can be unlimited risk. If you are forced to buy a security at a very high price, then you can see how this could be problematic.
Many people who start to dabble in the options markets do so by writing covered calls on stocks that they already own. This is the least risky place to start for most people, and it can generate extra income for you if done correctly. I’d advise not exposing yourself to high-risk strategies where you could lose everything. Especially if you aren’t completely sure about what you are doing.
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Writer and Investor. Based in the Pittsburgh, PA area, Brian holds full-time employment as a Warehouse Manager for an electronics firm. Brian enjoys wealth building, investing, gardening and the great outdoors. Brian holds a B.A. in Environmental Studies from the University of Pittsburgh and an MBA from Robert Morris University.