Say
you have a strong feeling that a particular stock is about to move higher. You
can either purchase the stock, or purchase 'the right to purchase the stock',
also known as a call option. Buying a call gives you the benefits of owning
a stock, yet requires less capital than actually purchasing the stock. A call
has a limited term and an expiration date.
Example:
General
Motors, (GM) is trading at $35, it would take $35,000 to buy 1000 shares of
stock. However instead of buying the stock you could purchase a GM ‘call
option’ with a strike price of 35 and expiration 1 month into the future.
For example in May you could Buy 10 GM May Calls for $2.35.
This will enable you to participate in the anticipated upside movement of
the stock while minimizing the downside risk of owning the stock.
Since each
contract controls 100 shares, you have bought the right to purchase 1000 GM
shares for $35 per share. The price, $2.35 is quoted on a per share basis, thus
the contract cost is $2350 ($2.35 x 100 shares x 10 contracts).
If the stock price
stays at or below $35 by expiration the most you could lose is $2350. On the
other hand, if the stock rises to $41 by expiration, the options will be trading
at around $6 (Current price: $41 - Strike price: $35). Your $2350 investment
will now be worth $6000 ($6 x 100 Shares x 10 contracts)
Using ShareCharts
Option Strategies for Long Calls the entire transaction can be seen clearly. Go
to Derivatives < Option Strategies and select Long Calls from the
‘Strategy’ Drop Down Box. Enter in all relevant parameters and click
‘Update’ to view the chart.
If the stock
price increases you have two options, sell or exercise the call option. Many
choose to sell as it avoids the substantial cash outlay involved in exercising
the call option. In our example of GM, to exercise you would pay $35,000 ($35 x
1000 shares) to buy the stock when you exercise the options. At the current
market price of $41, your shares would be worth $41,000. Not including brokerage
costs you would have a profit of $3650 ($6000 - $2350), or 10.4%.
Compare this to
selling the options. You will realize a profit without having to buy the shares.
With the stock at $41 the May 35 calls will have an approximate value of $6 per
contract. Thus, each option contract would have a value of $600 (6 x 100
shares). With the total value being $6000 ($600 x 10 contracts), or 255% an
excellent return for an investment of $2350.
With the downside
losses limited to the initial investment, and no limit to potential profits it
is easy to see why call options are such an attractive strategy for bullish
investors.