Buying calls is a type of option strategy that allows you to profit from a rise in the price of an underlying asset, such as a stock or an ETF. When you buy a call option, you pay a premium to the seller of the option, and in exchange, you get the right to buy the underlying asset at a fixed price (called the strike price) before a certain date (called the expiration date). You are not obligated to exercise your right, but you can choose to do so if the underlying asset’s price is higher than the strike price.
The main advantage of buying calls is that you can control a large amount of shares with a small amount of money, and benefit from the leverage effect. For example, if you want to buy 100 shares of a stock that trades at $50, you would need $5,000. But if you buy one call option that gives you the right to buy 100 shares at $50, you might only pay $300 as the premium. If the stock price rises to $55, you can exercise your option and buy the shares at $50, then sell them at $55, making a profit of $200 ($500 minus the $300 premium). This is a 66.7% return on your investment, compared to a 10% return if you bought the stock directly.
The main disadvantage of buying calls is that you can lose the entire premium you paid if the underlying asset’s price does not rise above the strike price before the expiration date. This means that buying calls is a risky strategy that requires a high degree of accuracy in predicting the direction and timing of the price movement. Also, buying calls involves paying commissions and fees, which can reduce your profit or increase your loss.
Basic Theory:
When you buy a call option, you are essentially paying a premium for the right to buy an underlying asset at a specified strike price before or at the option’s expiration date. This strategy is employed when an investor expects the price of the underlying asset to rise. The potential profit is theoretically unlimited, while the maximum loss is limited to the premium paid for the call option.
Procedures:
- Identify the Underlying Asset: Choose the financial instrument (e.g., stock) on which you want to trade call options.
- Determine the Strike Price and Expiration Date: Select the strike price at which you have the right to buy the asset. Choose the expiration date, specifying the period within which the option can be exercised.
- Assess the Premium: Evaluate the cost (premium) of the call option.
- Execute the Trade: Purchase the call option through your broker.
Explanation:
Let’s consider a practical example using Microsoft Excel. Assume you want to buy a call option for XYZ stock. The current stock price is $100, and you expect it to rise in the next two months. You decide to purchase a call option with a strike price of $110 for a premium of $5.
| Item | Value |
|---|---|
| Current Stock Price | $100 |
| Strike Price | $110 |
| Premium | $5 |
| Expiration (Months) | 2 |
Scenario:
You buy one call option contract, which typically represents 100 shares.
Calculation:
- Total Cost of Call Option:
- Total Cost = Premium × Number of Contracts × Contract Size
- Total Cost = $5 × 1 × 100
- Total Cost = $500
- Breakeven Price:
- Breakeven Price = Strike Price + Premium
- Breakeven Price = $110 + $5
- Breakeven Price = $115
- Profit/Loss at Expiry:
- If the stock price at expiration is above the breakeven price, you make a profit.
- If the stock price is below the breakeven price, you incur a loss.
- The profit or loss is the difference between the stock price and the breakeven price, multiplied by the contract size.
Result:
In our scenario, if the stock price at expiration is above $115, you make a profit. If it’s below $115, you incur a loss.
Other Approaches:
- Risk Management:
- Consider implementing stop-loss orders to limit potential losses.
- Diversify your options portfolio to spread risk.
- Technical Analysis:
- Use technical indicators to enhance your stock price prediction.
- Incorporate charts and trend analysis into your decision-making process.
