Buying Call Options on Robinhood Explained: A Beginner's Guide

Why Call Options?

Call options are appealing because they allow you to speculate on a stock’s price movement with less upfront capital than buying the stock outright. In essence, a call option gives you the right, but not the obligation, to buy a stock at a predetermined price (the strike price) within a certain time frame.

Let’s say you’re bullish on a company like Tesla, and you think its stock price will go up. Instead of buying 100 shares at the current market price, you could buy a call option that gives you the right to buy those shares at a set price (say $300 per share) sometime in the future, even if the stock has risen to $350 or more by then. If your prediction is correct, you stand to gain significantly. If it’s wrong, your losses are limited to the premium (the price you paid for the option) rather than the total price of the stock.

What Are You Really Doing When You Buy a Call Option?

Imagine you’re leasing a car with the option to buy it after a year at a predetermined price. If the car’s market value increases during that year, you’d buy the car and sell it for a profit. If the market value drops, you can walk away from the deal, losing only what you paid to lease it.

Call options work the same way. You’re essentially paying a fee (the premium) for the right to lock in the price of the stock (the strike price). If the stock’s price exceeds the strike price before the option expires, you can exercise the option to buy the shares at the lower price and sell them for a profit. If the stock price doesn’t move above the strike price, you simply let the option expire, and you lose only the premium you paid for it.

How to Buy Call Options on Robinhood

Now that you have a basic understanding of how call options work, let’s walk through the process of buying a call option on Robinhood:

1. Access the Options Chain:
   Once you're in the Robinhood app, find the stock you're interested in and tap on the “Trade” button. Next, select “Trade Options.” This brings up the options chain, which is a list of available call (and put) options for that stock, organized by expiration date and strike price.

2. Choose an Expiration Date:
   Every call option has an expiration date. This is the deadline by which the stock price must rise above the strike price for your option to be profitable. Longer expiration dates give the stock more time to move in your favor, but they also come with higher premiums. Shorter expiration dates are cheaper but riskier.

3. Select a Strike Price:
   The strike price is the price at which you’ll have the right to buy the stock. If the stock price exceeds the strike price by the time the option expires, you can exercise your option for a profit. When selecting a strike price, keep in mind that the further the strike price is from the current stock price (i.e., the more out of the money the option is), the cheaper the premium will be. However, these options are also less likely to end up profitable.

4. Understand the Premium:
   The premium is what you pay upfront to hold the call option. It’s calculated based on several factors, including the time until expiration, the stock’s volatility, and the difference between the current stock price and the strike price. When you buy an option, you’re paying for the possibility that the stock price will rise above the strike price before the option expires. If it doesn’t, the premium you paid is lost.

5. Place the Order:
   Once you’ve chosen the expiration date, strike price, and are comfortable with the premium, you can proceed to buy the option by selecting the number of contracts you want (each contract represents 100 shares of the underlying stock). Review your order, and if everything looks good, swipe up to submit it.

6. Monitor Your Option:
   After purchasing the call option, you’ll want to keep a close eye on the stock’s performance. If the stock’s price rises significantly above the strike price before the option expires, you can exercise the option, or alternatively, sell the option contract itself for a profit. If the stock doesn’t move in your favor, you can let the option expire, and your loss will be limited to the premium you paid.

Key Terms You Must Understand

• Strike Price: The price at which you can buy the stock if you exercise the option.
• Expiration Date: The last day your option is valid. After this date, your option expires worthless if you don’t exercise it.
• Premium: The price you pay to purchase the call option. It’s non-refundable.
• In-the-Money: A call option is considered “in the money” when the stock price is above the strike price.
• Out-of-the-Money: A call option is “out of the money” when the stock price is below the strike price.
• Time Decay (Theta): The closer you get to the expiration date, the faster the value of the option decreases if the stock price isn’t moving in your favor.

Pros and Cons of Buying Call Options on Robinhood

Let’s break down the advantages and disadvantages of buying call options.

Pros:

1. Leverage: Options provide leverage, allowing you to control more shares for less capital. If the stock moves in your favor, the percentage returns can be much higher compared to owning the stock outright.
2. Defined Risk: When you buy a call option, your maximum loss is limited to the premium paid. This gives traders a way to speculate on stock movements with less risk than shorting or buying on margin.
3. Flexibility: With options, you can speculate on short-term price movements or hedge long-term stock holdings.

Cons:

1. Complexity: Options are inherently more complicated than buying stocks, and the variables involved (strike price, expiration date, premium, etc.) can be overwhelming for beginners.
2. Time Decay: The value of a call option decreases as it approaches its expiration date. This means even if the stock price rises, the option may still expire worthless if it doesn’t rise fast enough.
3. Risk of Loss: While your losses are capped at the premium, buying out-of-the-money options is risky, and many options expire worthless. There’s a chance you could lose your entire investment if the stock doesn’t move as expected.

Strategy Tips for Success

1. Don’t Chase Far-Out-of-the-Money Options: Beginners are often drawn to far-out-of-the-money options because they’re cheap, but they’re also less likely to end profitably. Stick to options that are closer to the current stock price or slightly out of the money.
2. Start Small: Before you start buying multiple contracts or trading options on highly volatile stocks, start small. Even seasoned traders can make mistakes, and it’s better to learn from a $100 mistake than a $10,000 one.
3. Know Your Exit Strategy: Whether you plan to hold the option until expiration or sell it before then, always have an exit strategy in mind. This could be as simple as a percentage gain (e.g., sell when the option is up 50%) or a timeframe (e.g., sell if the stock doesn’t move after 3 days).

Conclusion: High Risk, High Reward

Buying call options on Robinhood can be a powerful tool for traders looking to profit from short-term stock price movements without committing large amounts of capital. However, they come with significant risks, especially for beginners. If you’re new to options trading, take your time to learn the mechanics and risks involved before diving in. With the right strategies and discipline, options can be a valuable addition to your trading toolkit.