When you are bullish on the market, you can buy call options to profit from an upward movement that occurs while you own the option.
A call is the right, but not the obligation, to purchase an asset at a specific price (the strike price), on or before a specific date (the expiration date).
For example, suppose XYZ Corp. is presently trading at $77 per share. If you expect the price to increase significantly over the next couple of months, you could purchase a call option to greatly leverage your profits from the expected movement. At present prices, you could purchase a call with a strike price of $75 and an expiration date a few months out for about $7.50. If you are correct and XYZ trades at $90 during the couple months while you are holding the option, the price of your option will likely double during that time period because the option will probably be priced near $15 (anyone holding that option has the right to buy XYZ at $75, but they can sell it at the current price of $90, yielding a $7.50 profit).
Although the underlying asset price increased less than 17%, your option on that asset increased by 100% or more. That’s the leverage that options can provide.
When you buy a call, your profit potential is unlimited. No matter how high the underlying asset price rises before expiration of your option, you reap the profits from that increase. Yet, your risk is limited. If the underlying asset price drops by $20, the most you can lose is the price that you paid for the option. In the example above, if XYZ drops to $57, the most you can lose is the price you paid. In this case it would be $7.50 per controlled share as opposed to the $20 per share loss you would incur had you purchased the underlying stock.
When we purchase calls, we generally purchase them at-the-money or in-the-money, because it lowers our risk of losing the premium. Although out-of-the-money options are much cheaper and provide greater leverage, there is a greater risk of loss. We generally buy them many months out to provide enough time for the market to make the anticipated move.
Options are not like stocks where you buy them and hold them. Time decay will continually erode your position and a change in trend can evaporate your profits quickly. It is recommended to set a specific target price for the option when you initiate the position.
As always, consult an investment professional before buying or selling options. Never invest in something you don’t understand. Be sure to always read an investment’s prospectus or disclosure statement carefully. If you can’t understand the investment and how it will help you make money, ask a trusted financial professional for help. If you are still confused, you should think twice about investing.
Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). It explains the characteristics and risks of exchange traded options. A copy of this document and supplements can be found here.
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