Buying Call Options

Module 3: Basic Strategies
Lesson 5: Buying Call Options

Buy Call options when stock prices are rising and you'll easily make 50-100% return on your money.

This is the strategy I have used most often and the one that has made me the most money.

It also requires significantly less money than buying stocks outright.

The lucrative aspect of Calls, or any stock option for that matter, is that a stock may rise in price by 1% and the same price movement will cause the option to rise in price by 10%.

You get more "bang for your buck".

This is one of the major reasons people trade stock options.

If you recall from the earlier lessons, a Call option gives its buyer the right, but not the obligation, to buy shares of a stock at a specified price on or before a given date.

Calls increase in value when the underlying stock it's attached to goes up in price, and decrease in value when the stock goes down in price.

Buying Calls

As in the case of buying Put options, you will most likely never exercise your rights to buy the stock. You just want to benefit from the movement of the stock without having to own it.

Risk / Reward
Maximum Loss: Limited to the premium paid for the option.
Maximum Gain: Unlimited as there is no limit to how high a stock can go.

Trade Example

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 Call Option. You would cash in your profits by either selling the Call or by exercising the option and then immediately selling the stock.

Closing Out the Position

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. You have to make the choice.

Advantages of Buying Call Options

• Allows you to participate in the upward movement of the stock without having to own the stock
• You only have to risk a relatively small sum of money
• The maximum amount you can lose on a trade is the cost of the Call
• Leverage (using a small amount of money to make a large sum of money)
• Higher potential investment returns

Disadvantages of Call Options

• The option has an expiration date so time works against you
• The stock has to make a move upward in order for the Call to increase in value
• If the stock stays flat or doesn't move, then the option will lose value due to time decay

You can proceed to Module 4: Stock Charts whenever you feel you are ready.

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