Aggressive Bets on Stocks: Call Options
If you are interested in making money in the stock market by making aggressive bets on the direction of a stock for a small investment upfront you’ll want to consider a Long Call Option. I’ll be explaining Call Options today…
What is a Call Option Contract?
By definition, a Call option is a financial contract that gives the option buyer the right, but not the obligation, to buy a stock at a future date at a given price. A call option makes money when the stock goes up in price.
Let’s break that down a bit.
- Contract… A call is an agreement between the buyer and seller that the seller is going to sell you shares of a stock on a future date for an agreed-upon price which is called a strike price.
- Right but not the obligation to buy… at that future date you have the option to convert your contract into 100 shares per contract or sell the contract outright in the open market.
- Future Date… There is a time component to an option contract. You pick a date in the future for when the contract expires. Most options expire on the third Friday of every month.
- Price… this is the price you pay to purchase the contract. Option premiums are quoted on a per-share basis, meaning that an option contract represents 100 shares of the stock.
A few notes additional on terms:
Strike Price is a defining point at which your contract will be “in-the-money” (ITM) which is when the underlying stock is above your strike or “out-of-the-money” (OTM) which is when the price is below your strike price.
Break-Even Price is the price at which your call option will begin to generate a profit. For example, as illustrated in the graphic below, if the strike is 100 and you paid $5 for your contract, your break-even will be $105. Thereafter you will make a profit dollar for dollar on the appreciation of the underlying stock.
Intrinsic Value is the difference between the underlying stock price and the option’s strike price when the option is in the money. For example, if the strike is $100 and the stock price is $105, your intrinsic value is $5.
Time Value of Money is the value of the contract when the underlying stock price is out-of-the-money with additional time left before expiration. For example, if the strike is $100 and the underlying stock is $95 with 30 days left before expiration, your time value is $5.
Why are Call Options Useful?
Long Call Options are great if you have a bullish outlook on the future price of a stock. The primary benefit of a long call option is that you limit your risk to the price of the contract and get the benefit of enjoying the value appreciation of 100 shares of stock.
Example of Call Options Being Employed
For example, as illustrated above, say you bought the 1 call option priced at $5. The cost of that contract is $500 ($5 x 100). Your total potential loss is only $500. The equivalent cost of purchase the underlying shares is $10,000.
If the stock price drops 10% ($10) by expiration your total loss for a call owner is $500. The total loss for a shareholder is $1,000. If the stock went up 10% ($10) for a call option holder, the value of that contract would be $10 ($1,000) which is a 100% return on investment. The equivalent shareholder would only be up 10% on their investment.
The Downside of a Call Option
The only downside to being a call option holder is that once the contract expires the price you paid for the contract is forfeit if the stock price is above the strike price. An equivalent shareholder has the benefit of time.
There are many strategies when it comes to options on how to make money in the stock market.
