by Ian Harvey
Call options are one of the two most important classes of stock options. The basic principle of trading these options is that if the price of the stock on which you buy an option rises, you make money.
This class of option gives the buyer the right, but not the obligation to buy an agreed quantity of stock (usually in lots of 100 shares) at a specified price known as the strike price. The stock may be purchased from the seller of that option contract before the expiry date. This date depends on the duration of the contract. Purchasing the stock is known as ‘exercising’ the option.
Simply put, this means that you are entitled to buy the stock at the strike price at any time you wish up until the expiry date*, no matter what price the stock is trading at. The seller is obligated to sell you the stock at the agreed price, even if it is trading much higher than the strike price at the time you wish to purchase.
To buy options, you pay a fee, or premium, to the seller of the options. This option premium is a fraction of the cost of the underlying stock, and rises or falls proportionally. For example, an option on a share with a market value of $25.00 may cost $1.20 per option. This would mean an investment of $120.00 to buy a lot of 100 options. There is also a commission which is paid to the broker of the sale.
When you purchase call options, you do so because you are expecting the price of the stocks to rise. The potential gain is large if the price of a stock rises well above the price you can buy it for (strike price). The profit that you can make is limited only by how high the underlying stock can rise within the period of the option contract.
If the price of the stock has risen to a price that is higher than the strike price, the option is said to be ‘in the money.’ To buy options with the potential of being in the money is one of the most basic and effective strategies for profiting from call options.
When an option is in the money, there are two ways that you can make a profit.
The first way is to exercise your option, and buy the underlying shares at the strike price. In the above example, this at a price of $25.00 per share. This would require an outlay of $2500.00 to purchase the 100 shares that your options entitle you to buy. If the market value has risen to $27.00, then you can sell those shares for $2700.00, giving you a profit of $200.00. You also need to calculate how much commission will come out of that amount, and decide whether the potential gain warrants the outlay of a substantial amount of capital.
The second way to make money on your options is by selling the options at a higher rate than what you paid for them. If the price of the stock has risen from $25.00 to $27.00, a conservative estimate is that the options you bought for $1.20 would have risen to $1.50. By selling those options which cost you $120.00 for a total of $150.00, you are generating an immediate 25% profit. Alternatively, you can hold onto the options if you believe that the price will continue to rise further, and sell them closer to the expiry date for an even bigger gain.
If the price drops, or fails to rise above the strike price, the risk is limited to the cost of the premium and commission. In this instance, you would obviously choose not to exercise the option. It would not make sense to purchase the shares at $25.00 from the seller of the option, when you could purchase those same shares for $23.00 in the stock market.
In deciding whether or not to sell an option that has dropped in value, you have to decide whether you believe that there is a good chance that the drop will be reversed within the time of your contract, or whether to cut your losses and recoup a portion of your investment on the premium rather than risking a bigger loss by holding onto the option.
Keep in mind that buying call options is not buying physical financial assets, but rather it is buying the right to future purchases.
*Options on stocks in the American stock market may be exercised at any time up to the expiry date. Options on European stocks can only be exercised on the day of expiry.
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