Back to basics: call options

Davis MartinDavis Martin ·

Ever look at a high-priced stock and want to buy it but it’s too pricey given how much cash you have to put to work? Options let you get around that problem, giving you exposure to a stock or ETF and the ability to profit from its price movements in a cost-efficient manner.

Here’s a brief tutorial on how you to use call options when you’re bullish on a stock.

Call options defined

If you purchase and hold a call option, you have the right to buy 100 shares of the stock at a specified price — known as the strike price — on or before the option’s specific expiration date.

You’re not obligated to exercise your call option. If the call option expires one penny above the specified strike price, you would automatically be exercised and long the stock at the strike price. Keep in mind that there are a lot of factors affecting the price of an option, including the implied volatility, time to expiration, the underlying stock’s price, interest rates and dividends. However, we’re just focused on the basics here.

Here’s an example to give you a better idea of how call options work.

Check out the sample PnL graph of a call option at expiration.

Generally, call options tend to be cheaper than buying shares.

Let’s take a look at an example. Assume you purchased one call option on Amazon.com Inc. (AMZN), expiring one month from today, for $5. Equity options generally have a multiplier of 100, and therefore, your total investment would be worth $500. Assume the stock is currently trading at $900, and based on your analysis, you believe the stock could go to $1,000. Therefore, your strike price would be at $1,000, and if the stock rises to $1,000 before the call option expires, your option would be considered in the money. If the stock rises to $1,000 before the option expires, the option would gain in value, all else being equal.

If the stock price does not rise to $1,000 and you hold it to the expiration date, your maximum loss would be just what you invested into the call option on AMZN, or $500.

Final thoughts

Options are difficult to understand but are worth trading because of the buying power they give you. Call options are a cost-efficient way to place bullish bets on specific stocks, but you must be comfortable with the nuances of trading them before you take the plunge.

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Davis Martin is the lead publisher at DailyProfitMachine.com. He trades SPY calls and puts and swing trades mid-large cap stocks and stock options.

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