Believe it or not, there are many factors that go into learning how to pick the right call option to buy…
In fact, one of the biggest mistakes beginner traders make is focusing too much on the call option’s price instead of their objective, or the reason they’re purchasing it.
A better way to pick a call option is to determine what it’s worth and how much value you can gain from it.
The biggest factor that should go into deciding which call option to buy is the anticipated movement in the underlying asset, and the timing of how long that move will take…
Only then can you determine how to pick the right call option with any degree of certainty.
How to Pick the Right Call Option
There are three main types of call options…
- Out of the Money (OTM) – This is the cheapest type of call option. The strike price for the option is far above the price of the underlying asset. This type of option is typically bought when the call buyer anticipates a strong move within a short time.
For example, if the price of the underlying stock is $50 per share, an OTM call option with a strike price of $60 would be out of the money.
This option would require the price of the stock to move a lot higher for it to begin gaining much value.
- At the Money (ATM) – These call options are purchased when the buyer expects a medium-sized move within a short period of time. An ATM call option is a popular choice for swing traders because it doesn’t require a strong move to begin gaining value.
For example, if the price of the underlying stock is $50 per share, an ATM call option would be the $50 strike price.
This call option would be more responsive or sensitive to the movement of the underlying stock price, and would move about $0.50 for every dollar it gains.
- In the Money (ITM) – These call options are purchased when the call buyer expects the option to move close to the movement of the underlying stock.
ITM call options are a viable choice when the underlying stock is expensive and the trader wants to participate in the movement of the underlying stock, but doesn’t want the downside exposure that comes with owning the actual asset.
The trader also might not want to spend — or doesn’t have a large enough account to purchase — the amount of shares needed.
For example, if the price of the stock is $200 per share and the trader wants to purchase 100 shares, the trader will need $20,000.
If the trader decides to purchase ITM call options, the cost would be $25.
So the cost of 1 contract (100 shares) would be $2,500 instead of the $20,000 needed to purchase 100 shares of the underlying stock.
In addition to deciding which strike price you should purchase, the second part of learning how to pick the right call option is deciding how much time you need.
You have to keep in mind that options decay or lose a major portion of their value during the last month prior to expiration.
So I don’t like to purchase call options with less than one month till expiration… unless I expect an imminent price move in the underlying asset.
If you’re day or swing trading and intend to hold the call option for a few hours or days, then buying options with less than one month of time value may be a good choice. That’s because the less time value the option holds, the cheaper it will be.
But the odds of it expiring worthless are high…
On the other hand, if you don’t know or have a good sense of how long it’ll take for the underlying asset to begin moving, then buying call options with a few months until expiration could be a good idea.
This way the option will decay slower, giving you a bigger time window for the underlying asset to make the price gain needed for the option to move higher and gain more value, which is the ultimate goal.
So when learning how to pick the right call option, always take the strike price and timing of the underlying asset into consideration.
It’s a much better process than focusing just on the price of the call option.
This should help you increase your odds of purchasing options that end up expiring in the money instead of out of the money or worthless.
If you’d like to learn more about trading options, check out this article: Learn to Swing Trade Options With This Beginner-Friendly Strategy.
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All the best,
Senior Strategist, WealthPress