A Beginner's Guide to Buying Calls

How to utilize leverage for big returns on small investments

Jan 13, 2015 at 11:14 AM
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For many years, options were the dark, unknown side of the stock market. Typically viewed as risky investments, the predominant mindset was that they weren't ideal for the average trader. But ever since the proliferation of the Internet and electronic trading, options have exploded into one of the most popular forms of investing -- whether as a straightforward means of accruing profit or as a way to protect another facet of one's portfolio.

So, what the heck are options, anyway? Essentially, a stock option comes in two forms -- calls and puts -- and is a contract that allows the purchaser the opportunity to buy (calls) or sell (puts) 100 shares of a specific stock at a predetermined price on or before a predetermined date. In simpler terms, an option buyer is betting on the stock's trajectory within a certain time frame. Below, we will be discussing the basics of call buying.

Here is how it works. Let's say that a potential investor -- "Jim" -- believes that shares of 'XYZ' are going to skyrocket over the next few months. However, Jim doesn't want to fork over all of the cash necessary to purchase a significant amount of XYZ shares. So, he decides to buy a call option at the price that he thinks XYZ is going to topple -- known as the "strike price."

Advantages of Call Buying

Specifically, let's say that XYZ is currently trading at $50, and rumors of an impending CEO swap in early February have Jim convinced that the stock will be going up significantly. Jim could buy the February 50 call, which expires at market close on Friday, Feb. 20. The ask price for that option is $5, and since every option contract represents 100 underlying shares, the price for one contract would be $500 ($5 ask price x 100 underlying shares). For comparison, it would cost $5,000 for Jim to control 100 XYZ shares outright ($50 x 100 shares).

Since XYZ is trading at $50 -- around the strike price -- the call is considered "at the money." The contract will move "in the money" if XYZ powers north of $50 within the option's lifetime, and will move "out of the money" if XYZ sinks south of $50 by expiration.

If Jim's bullish prediction is right, he can exercise the option, which means he can buy 100 shares of XYZ at $50 apiece, the pre-determined strike price -- a discount to the current market value. He could also sell to close the call, where he would simply sell the in-the-money contract for a profit. Whatever he decides, he must heed the expiration date. Starting in February, monthly options will expire at market close on the third Friday of each month, though many popular stocks also have weekly options that expire every Friday.

Let's dig deeper into Jim's potential outcomes. First, let's assume that he is correct, and the announcement of the new CEO sends shares of XYZ all the way up to $65. He could sell to close his option (now worth $15 in "intrinsic value" -- stock price less call strike) before expiration, for $1,500 ($15 x 100 underlying shares). Since Jim only paid $500 for his option contract, his total profit would be $1,000, for a crisp 200% return on his initial investment.

As alluded to earlier, had Jim taken a long position on XYZ, purchasing 100 shares would've cost him $5,000. After the stock's ascent to $65, his shares would be worth $6,500 -- a gain of $1,500. While this is $500 more than the profit he would have made off the 50-strike call, it only represents a 30% gain on his initial investment of $5,000. So even though Jim would have made more money buying the actual shares instead of an option, he risked $5,000 for a 30% gain. On the other hand, the option only risked $500 for a 200% gain. This is called leverage -- or the principle of wagering relatively modest amounts of money in order to win profits far in excess of the original bet.

Possible outcomes for XYZ 50-strike call

On the flip side, let's say XYZ tanks to $40 before February options expiration. In this instance, Jim the Call Buyer would be out just the $500 paid for the option, while Jim the Stock Buyer would be out a whopping $1,000 ($5,000 - $4,000), which would steepen as XYZ tanked.

In conclusion, calls are like having a long position on a stock, but they don't require large amounts of capital upfront to buy, and your risk is limited. If Jim were to have a long position on XYZ, his potential losses could be massive, considering the stock could theoretically plummet to zero. With a call, his losses are capped at the premium he paid for his contract, but his profits are theoretically unlimited, as the stock price could hypothetically increase indefinitely above the strike-price for his call.

Stay tuned next week for an intro to put buying, the other basic type of options contract.

Disclaimer: None of the hypothetical scenarios above take into account brokerage or commission fees, which are an inescapable part of options trading.


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