A call option (or “call”) is a derivative contract between a buyer and a seller. The call option allows the buyer of the option the right (but not the obligation) to buy shares of a security, such as a stock at a specified price, known as the strike price and at or before a scheduled date. On the other side of the contract is the seller who is obligated to sell the stock to the buyer at the agreed upon price if the buyer decides to exercise their option.
By purchasing a call option, an investor is hedging that the price of the stock will increase and is hoping to profit from that by purchasing the call option. In general, the more calls that exist for a stock (i.e. those with a high call option volume) is a bullish signal for that stock.
In this article we’ll review call option volume along with some basic terminology surrounding call options. We’ll also go into detail about the options volume theory and discuss why call options volume is not a standalone indicator for successful trading.
How is a Derivative Contract Different from Direct Stock Ownership?
In most cases, trading stocks involves the direct ownership of shares. If an investor buys 50 shares of a company like Microsoft (NASDAQ: MSFT), they immediately have those shares in their brokerage account.
That’s not the case with options trading. With options trading, traders buy and sell contracts called derivatives, in which they put up money that allows them, but does not obligate them, to buy or sell shares of a stock at a specific date and at a specific price.
Two of the most common derivatives contracts are call options and put options. With that in mind, it’s important to understand some of the key terminologies that is part of options trading.
Key Terms to Help Better Understand Call Options
Strike price – this is the target price that a buyer sets as the minimum the stock has to rise to for them to consider picking up the option they purchased. So for example, if an investor wants to buy a call option on Pepsi stock that is trading at $116 per share, they may look for a call option with a strike price of $119. If Pepsi’s stock rises to that level, the call option allows them to buy the shares at $116 and then they can immediately sell the shares for $119. The result is a $3 per share profit.
Expiration date – this refers to the last date the option can be left open. On or before this date, the buyer of the option must “call” the option otherwise the option is allowed to expire. The expiration date is fixed as the 3rd Friday in the month that the option is expiring.
Premium – this is another word for the cost of the contract. Think of it like a transaction fee when you buy tickets for some event online. The price of the premium is set based on the value of the stock. As the stock price rises, the premium goes up. The important thing to remember about a premium is that for the buyer of the option, this is the only capital that they are truly putting at risk in the event they decide not to exercise (or “call” the option).
In the money – a term used to describe a call option that would be worth more than $0 if sold on the open market. In our example above, if a buyer purchased a call option for Pepsi stock that was currently trading at $116, the trade would be considered “in the money” as soon as the price rose to $116.01.
At the money – a term used to describe a call option where the market price of the stock is the same as the strike price. For our Pepsi example, that would mean the stock price was at $116.00.
Out of the money – this is a term that describes a call option where the market price of the stock fell below the strike price. In our example, this would mean that after purchasing the call option, the share price of Pepsi fell below $116. The buyer of the call option would simply allow the contract to expire “worthless” and they would only lose the premium that they paid for the call option. Call options that are out of the money are referred to as “otm call options”.
Bid-Ask Spread – this refers to the difference, expressed as a percentage, between the highest purchase price being offered for a security and the lowest offered sales price for the same security. A wide bid-ask spread usually indicates lower volume while a narrow spread usually indicates high volume. This is because as the bid/ask spread becomes narrower, the call option will be closer to being “in the money” and therefore more desirable.
What Do Changes in Call Option Volume Indicate?
Volume is the amount of buying and selling that is being done by a security. Equities, such as stocks along with futures, currencies and other investments all measure trading volume. Putting it all together, call option volume refers to the amount of buying and selling activity for call options of a particular security.
In general, a call option will have high volume when it is close to its “in the money” price. This is because many more investors will be attracted to the security. Conversely, as the stock price of a call option contract moves further “out of the money” the call option volume will generally decrease.
Analyzing Options Volume Takes the Emotion Out of Trading
Trading options based on volume assumes that the trading activity is being done by informed stock traders. There is no emotion to options trading. It is risk neutral and can be highly competitive. A lot of options trading is done by hedge funds and other institutional investors. They make will buy or sell a call option based on what they believe regarding the price direction of the stock.
If the trader anticipates good news about a stock, such as an earnings report that is expected to beat analysts’ expectations, then they will look to buy call options. Since the trader is anticipating that the share price will be increasing, they would be fine with buying the stock outright. However, the options contract will allow the investor to leverage their buying power.
On the other hand, if the trader anticipates bad news about a stock, they will look to sell call options. This means that they are hoping to find buyers that have a different opinion of the stock who will pay them a premium to buy their call option.
As you can see, options volume is a complementary trading signal. If there is a volume on call options that is accompanied by a rising price for that call option indicates that professional traders believe the price of the stock is going to go higher. If there is high call option volume that is accompanied by a declining call option price, it is a signal that there is speculation that the stock price will go lower.
The Role of Implied Volatility with Call Option Volume
Implied volatility is the expected volatility of the underlying stock contained within the call option. Implied volatility effects the premium that the seller of the option is paid. When there is high call option volume, there is an expectation that the stock price will increase. This increases the level of implied volatility as the market expects that more traders will seek to buy the options. Since the market is continuously adjusting the premium that a buyer will have to pay for the option, a high level of implied volatility increases the premium for the option. Implied volatility will decrease when demand for a call option is low. In response, the premium for the option will also decrease.
Implied volatility is also closely related to the option’s expiration date. If the expiration date is drawing near, the option will be less sensitive to implied volatility. Longer-dated options will be more sensitive because there is a greater likelihood that the option would move to an “in the money” state. However, once an option is “in the money” or “out of the money” it will be less sensitive to implied volatility.
Do Call Option Volumes Accurately Predict Stock Price Movement?
The answer is sometimes, but certainly not always. Call option volumes are not a stand-alone indicator of price movement. But, if supported by other technical and/or fundamental indicators, they can support the direction of a trade. One key fundamental indicator that can support a significant change in call option volume is an approaching earnings call. In general, if analysts expect a company to report positive results, it will usually correspond to an increase in call option volumes as more investors look to buy the stock. Likewise, a negative expectation may also increase call option volumes. However, in this case traders would be looking for the price of the underlying stock to decrease; therefore they would be attempting to sell the call options.
Some investors will look at technical indicators to help assign a context to a call option that has high volume. For example, if a stock’s daily trading volume is breaking out of its moving average for a defined period of time (20-day, 50-day, 200-day, etc.) then that may indicate that the stock price is ready to make a big move in the trending direction.
Call option volume can change in a positive or negative direction whether the economy is in a bull market or bear market. An individual stock or futures contract may respond in the opposite direction of the broader stock market.
The Final Word on Call Option Volume
Call option volume is evidence that the underlying stock contained in the option is going through a period of volatility. When high call option volume is matched by an increasing or decreasing share price, it usually indicates the existence of a trend that can set up a successful options trade.
A call option is an options contract between a buyer and a seller. The seller of the call option collects a premium for selling the option to the buyer. The buyer benefits from the call option because they get to speculate on the future price direction of the underlying stock or futures contract without having to commit significant dollars to purchase the shares outright. During earnings season many stocks can report high call option volumes as analysts speculate whether a company will meet, exceed or miss on expectations as well as what the company has to say about their future prospects.