Ever look at a high-priced stock and want to buy, but couldn’t do it? Options let you get around that problem. Option provide you with 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, or the strike price. Now, the right only lasts until 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. Consequently, you would be long the stock at the strike price. Keep in mind, 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.
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 Facebook (FB), 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 $150, and based on your analysis, you believe the stock could go to $160. Therefore, your strike price would be at $160, and if the stock rises to $160 before the call option expires, your option would be considered in the money. If the stock rises to $160 before the option expires, the option would gain in value, all else being equal.
If the stock price does not rise to $160 and you hold it to the expiration date, your maximum loss would be just what you invested into the FB call option, or $500.
Now, sometimes it’s more beneficial to use call options to express your opinion on a specific stock or an index.
Since options give you leverage, you can have outsized gains.
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. However, you must be comfortable with the nuances of trading them before you take the plunge.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.