Buying a Call option is a low risk way of profiting from a rising stock. An investment in a stock option cost as much as 90% less than buying the stock, yet you can make the same amount of money.
And you have less money at risk of being lost.
Most people invest in stocks to make money which isn't smart.
You should invest in stocks for ownership. If you want to make money just buy stock options.
It will cost you a whole lot less and you can make the same amount of money.
Let's say you bought an IBM July 95 "Call option". This stock option gives you the "right to buy" IBM stock for $95 on or before the 3rd Friday of July.
Now imagine that IBM comes out with a new product and the stock shoots up in price to $127. You own a contract (Call option) that says you can purchase it for $95 a share.
Think shopping, you get to buy it at a $32 discount when everyone else has to pay the full retail price.
So as the stock goes up in price, the 95 Call option goes up in value. A $140 stock price means you get a $45 discount in price etc. etc.
If the stock falls in price to $50, then no one will want to buy your option and it will essentially be worthless.
Who would want to purchase a contract that gives them the right to buy a stock for $95, when it's selling for a cheaper price on the open market?
If you bought the option while the stock was trading at $50 and exercised the rights of the contract you would have to buy the stock for $95. You would pay $95 for a stock that is trading for $50 on the open market. You'd immediately be at a loss of $45!
That's the equivalent of someone trying to sell you a car for $2,000 when the car is selling everywhere else for $1,500.
So when an individual believes that a stock is going to rise in price, they can profit from this movement by purchasing a stock option.
You would cash in your profits by either selling the Call or by exercising the option and then immediately selling the stock.
I have looked up the option's actual historical prices to show you how this IBM trade would have looked if a trader decided to sell his/her Call:
These were the actual historical prices from the option chain. As I mentioned in the buying Put options tutorial, the in-the-money (ITM) options "generally" rise in value dollar for dollar with the stock price.
If you will note in the calculations above, the stock price of $127 minus the strike price of $95 equals exactly $32. The investor bought the At-The-Money (ATM) option for $7.
From this point the option moved up in price dollar for dollar with the stock price.
You can also use Calls to lock in a good price for the stock.
If the investor feels that the stock may rise in price, but doesn't quite feel comfortable risking a significant amount of capital he/she can buy a call option.
Once the stock does in fact rise in price, he/she can now exercise the rights of the contract and buy the stock. Let's take a look to see how the trade turns out when the investor decides to exercise the rights of the option contract:
At this point the investor can either hold onto to the stock or immediately sell it on the open market for $127.
If the stock did NOT rise in price and instead traded below the $95 strike price then the option would be Out-of-the-Money (OTM) and its value would decline.
If the stock continued to fall or you reach the option's expiration month then its value will eventually fall to zero dollars, costing you 100% of your investment.
You will often hear people talk about options expiring worthless. This is the term used for when an option falls in value to zero dollars.
So when you feel a stock is going to rise in price you can either buy the stock outright or use a call option. Using stock options just adds leverage.
The choice on which to use is up to you. Pick the one that best meets your investment objections.
Module 3: Basic Strategies