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Buying Call Options

Buying a call option (“a call”) gives you the right, but not the obligation, to purchase an underlying security at a predetermined price for a certain time period. Call options are available in various strikes and expiration dates. Expiration dates very from as short as one month to as long as a year or more. You are betting that the underlying security will rise within the time that your option is valid, as a call options buyer. The amount you paid for the option, is the maximum risk you take by buying a call option; in other words, you cannot lose more than the premium you paid for the call. Depending on the price increase of the underlying security is the extent of you potential profit. The long call becomes more valuable, as it goes up, because you have paid for the right to buy the underlying security at a given strike price. That is the reason why traders buy call options in a rising or bull market.

Here is a simple example:

Let’s assume that a particular stock currently trades at $40. You can buy a call with an expiration date three months into the future and a strike price of $44. You paid $1 per contract for the right, but not the obligation, to buy 100 shares of the underlying stock for $44.

Now , what if the stock goes up to $50 within the next three months, (i.e., before the option is due to expire). By demanding from the call seller (the option “writer”) that he or she sells the stock to you for $44, because now you can exercise your call option. Because you can sell the stock immediately at the current market price of $50, you have made a $6 (600%) profit, minus, of course, the cost of the option purchase.

If we assume the stock has declined to $35 by the time the option expires, on the other hand, it would not make sense to exercise the call and buy the stock for $44. You would let your option expire worthless, in this situation, and take a loss of $1 per contract. It is the seller of the call who will realize a profit of ($1 per contract) in this case.

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