Buying Call Option Example – How Buying Call Options Can Boost Your Stock Market Returns

Buying Call Option Example - How Buying Call Options Can Boost Your Stock Market Returns

Buying Call Option Example

Buying Call Option Example - How Buying Call Options Can Boost Your Stock Market Returns

In this article, we will look at how buying call options can help traders and investors boost their returns. The main key is to buy options sparingly, in small quantities. 90% of your portfolio should still be invested in such things as stocks and funds. The remaining 10% can be set aside for the big, historical up moves that infrequently occur as the result of fundamental shifts in supply and demand.

Buying Call Option Example - How Buying Call Options Can Boost Your Stock Market Returns

First, let’s examine call options:

Buying Call Option Example - How Buying Call Options Can Boost Your Stock Market Returns

A call option on a particular stock is a contract to buy 100 shares of that stock at a certain price (strike price) by the third Friday of a certain month (expiration month). To trade a call option, the trader needs to specify the stock’s base option symbol (different from its stock symbol), the option strike price, and the expiration month.

Buying Call Option Example - How Buying Call Options Can Boost Your Stock Market Returns

The buyer of a call option pays a premium to the option seller. This amount is the maximum amount that the call buyer can lose. The buyer now has the right to exercise the option before it expires. This will allow him or her to buy 100 shares of the stock at the strike price. The call buyer does not have to exercise the option. For example, if the stock is trading at or under the strike price at expiration, then the buyer is better off buying the stock normally.

Buying Call Option Example - How Buying Call Options Can Boost Your Stock Market Returns

Most options buyers, however, are not interested in exercising the call and buying the stock. Instead, they are hoping that the stock price increases and/or becomes more volatile – causing the option itself to increase in value. Then, they can sell the option for profit. Buying Call Option Example

The option seller, on the other hand, gets to keep the premium that the buyer paid for the option. This is the maximum amount that the call seller can earn. The seller has no control over whether or not the option is exercised, but he or she is obligated to deliver 100 shares of stock if the call option is exercised. If the option seller does not already own the stock (in which case, his position is known as a covered call), then he or she must buy the stock on the open market. In this case, if the difference between the stock price and strike price is more than the options premium, then the call seller loses money.

For our purposes, we will stick to buying call options. This gives us limited risk, but an unlimited upside if a stock increases substantially before expiration. Because the option buyer has to get the timing right, buying call options should be limited to those situations where a stock trader is confident that a move will occur.

For example, as the stock market was tanking at the end of 2008, and congress was passing the bailout legislation, an astute trader could have been buying small quantities of cheap, out of the money calls.

Call options are “out of the money” when the stock is currently trading below the strike price. For example, if Apple stock is currently trading at $ 165, then call options with a strike price of $ 170 would be out of the money. A buyer would currently have no advantage in exercising the option, because they can buy the stock cheaper on the open market. This call option might only cost 75 cents, because all the value rests in the potential of Apple stock to rise above $ 170.

If, when the market turned, Apple stock ended up at $ 180, then each 75 cent call option would be worth a minimum of $ 10. This is an increase of 1,333%!

The thing to remember with options is that the pay off can be very high, but the success rate is low, because the timing must be right. Even though, on paper, it would seem that putting 100% of your account into options and making 1,333% will make you rich, the correct course of action is to limit your investment to 10% of your funds or less. Buying Call Option Example

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