A cash-backed call option, also known as a cash-secured call, is an option strategy where an investor buys a call option while setting aside enough cash to buy the stock at the strike price.
A cash-secured call is used when an investor wants to purchase a long-term bullish stock at the price he is willing to pay. After reading this article, investors will understand how to implement this strategy into their own investing portfolio.
By using this strategy, the buyer of the option establishes a maximum purchase price for the underlying stock, while leaving the opportunity to take advantage of a downturn in the stock’s price.
If the stock’s price rises above the strike price by expiration, then the option will be “in-the-money” and could be exercised. If exercised, the buyer of the option would buy shares of the stock at the strike price.
If the stock falls and is below the strike price at expiration, then the option will expire worthless. With the stock at a new and lower market price, the investor could use his set aside cash to purchase the stock at that price. The investor would do this if he was still long-term bullish on the stock.
If the investor does not purchase the stock at the lower price because he is no longer bullish, then the maximum amount the investor will lose is the premium he paid for the option.
Example:
Assume shares of stock XYZ are trading at $53. An investor, who expects the price of XYZ to rise in the long-term, implements a cash-secured call by buying a call option with a strike price of $55 while setting aside $5,500. $5,500 is the maximum amount the investor will pay for shares of XYZ. This is equal to the strike price times 100 shares of stock (one option contract equals 100 shares of stock).
The investor pays a premium for the call option that costs $2 per share, or $200 total. This is the investor’s potential maximum loss when using this strategy.
At expiration, if the stock is above the strike price of $55, then the call option could be exercised. The investor would have the right to buy shares of the stock at $55 with the expectation that the stock’s price will continue to rise.
At expiration, if the stock is below the strike price of $55, then the call option would expire worthless. However, if the investor was bullish on the stock still, then he has cash set aside to purchase the stock at the lower market price. If he was no longer bullish on the stock, then he would walk away from the trade and lose the $200 premium.
By using this strategy, investors either purchase shares of stock at the price they want, purchase shares of stock at a price lower than what they are willing to pay, or walk away from a stock that they are no longer bullish on without losing any significant money besides the premium. The cash-backed call is a useful strategy for investors to get the stock they want at the price they want.
