An investor who is very bullish on a particular stock.
An investor who would like to take advantage of what purchasing options offers: leverage with a limited dollar risk.
An investor who anticipates a rise in the value of a particular stock but does not want to commit all of the capital needed to purchase the stock.
Buying a call is a simple option strategy and one that is often used. Although buying calls may not be suitable for everyone, it allows the investor the opportunity to profit from an upward move in the underlying stock while having very little capital at risk compared to the amount needed to own the stock.
Definition
Buying a call gives the owner the right, but not the obligation, to buy the underlying stock at a specified price (the strike price) within a specific period of time. The risk for the call buyer is limited to the premium paid for the call (the price of the call) plus commissions. The profit potential is unlimited as the underlying stock rises above the breakeven price (strike price plus the premium paid for the call plus commissions.) The value of the call tends to increase as the price of the underlying stock rises. This gain will increasingly reflect a rise in the value of the underlying stock when the market price moves above the option's strike price.
How to Buy a Call to Participate in the Upward Movement of a Stock While Limiting Your Downside Risk
In this example ZYX is trading at 44 1/4. Instead of spending $22,125 for 500 shares of ZYX stock, an investor could purchase a six-month call with a 45 strike price for 3 3/8. By purchasing a six month call with a 45 strike for 3 3/8, the investor is saying that he anticipates ZYX will rise above the strike of 45 (which is where ZYX can be purchased no matter how high ZYX has risen) + 3 3/8 (the option premium), or 48 3/8, by expiration. Each call represents 100 shares of stock, so 5 calls could be bought in place of 500 shares of stock. The cost of 5 calls at 3 3/8 is $1,687.50 (5 calls x 3 3/8 x $100). Instead of spending $22,125 on stock, only $1,687.50 is needed for the purchase of the 5 calls. The balance of $20,437.50 could then be invested in short-term instruments. This investor has unlimited profit potential as ZYX rises above 48 3/8. The risk for the option buyer is limited to the premium paid, which in this example is $1,687.50. Commissions and taxes have not been taken into consideration in these examples, although they can have a significant affect on the investor's returns. Buying 5 ZYX 6-Month 45 Calls at 3 3/8 vs. Buying 500 Shares ZYX @ 44 1/4. We will discuss three possible scenarios at expiration.
I. ZYX is above 48 3/8 by expiration.
If ZYX is at 51 at expiration, the option will be worth the difference between the strike and the current price of the stock: $51 (current price) -45 (strike price) $ 6 (current option value) The option could be sold and a 77% return would be earned on the initial investment. $6 (current option value) $3 3/8 (premium paid for option) $2 5/8 (profit, if option sold) The 5 calls could also be exercised and 500 shares of ZYX would be purchased for $45 per share even though the stock is trading at $51 per share. The right to buy the stock at 45 cost 3 3/8 so the breakeven on the stock position in ZYX is 48 3/8 plus commissions. Had the stock been purchased at 44 1/4 (a cost of $22,125), and it rose to 51, it would now be worth $25,500. This would be a 15.3% increase in value over the original cost of $22,125. But, the call buyer spent only $1,687.50 and earned 77% on his options.
Had Stock Been Purchased
Stock Purchase Price
Initial Cost of Stock - 500 Shares
Stock Price at Exp.
Value of Stock at Exp.**
Change in Stock Value
44 1/4
$22,125
51
$25,500
$3,375
Had Call Options Been Purchased
Option Price Per Contract
Initial Total Cost - 5 Options
Option Price Per Contract at Exp.
Total Value of Options
Change in Options Value
3 3/8
$1,687.50
6
$3,000
$1,312.50*
*Plus interest earned on cash not used, cost of stock less call premium. **Plus dividends if any.
II. - ZYX is between 45 and 48 3/8 at expiration
The investor's option will still hold some value if the underlying is between 45 and 48 3/8 (breakeven), but not enough to breakeven on the position. The option can still be sold to recoup some of the cost.
For example, ZYX is at 47 on the last day of trading, usually the third Friday of the expiration month. The option can be sold to close out the position through the last trading day of the call. ZYX did rise in value, but not as much as anticipated. The option that cost 3 3/8 is now worth 2 points. Instead of letting the option expire, you can sell the call and recoup some of your losses.
3 3/8 = (Cost) -2 = (Sale) 1 3/8 = Net loss (excluding commissions)
If just the stock had been bought and the stock rose to 47, $1,375 would have been earned while the holder of calls would have lost $687.50. However, the holder of calls would have been earning interest on $20,437.50, which would offset some of the loss in the options.
Had Stock Been Purchased
Stock Purchase Price
Initial Cost of Stock - 500 Shares
Stock Price at Exp.
Value of Stock at Exp.**
Change in Stock Value
44 1/4
$22,125
51
$25,500
$3,375
44 1/4
$22,125
47
$23,500
$1,375
Had Call Options Been Purchased
Option Price Per Contract
Initial Total Cost - 5 Options
Option Price Per Contract at Exp.
Total Value of Options
Change in Options Value
3 3/8
$1,687.50
6
$3,000
$1,312.50*
3 3/8
$1,687.50
2
$1,000
($687.50)*
*Plus interest earned on cash not used, cost of stock less call premium. **Plus dividends if any.
III. ZYX is at or below 45 at expiration.
ZYX is now at 40 and the option has expired worthless. The premium that was paid for the calls has been lost. However, had the stock been bought the investor would now be in a losing stock position hoping to breakeven. By purchasing a call he had limited capital at risk. Now he still has most of the money that he would have spent to buy the stock plus interest and he can make another investment decision.
Had Stock Been Purchased
Stock Purchase Price
Initial Cost of Stock - 500 Shares
Stock Price at Exp.
Value of Stock at Exp.**
Change in Stock Value
44 1/4
$22,125
51
$25,500
$3,375
44 1/4
$22,125
47
$23,500
$1,375
44 1/4
$22,125
40
$20,000
($2,125)
Had Call Options Been Purchased
Option Price Per Contract
Initial Total Cost - 5 Options
Option Price Per Contract at Exp.
Total Value of Options
Change in Options Value
3 3/8
$1,687.50
6
$3,000
$1,312.50*
3 3/8
$1,687.50
2
$1,000
($687.50)*
3 3/8
$1,687.50
0
0
($1,687.50)*
*Plus interest earned on cash not used, cost of stock less call premium. **Plus dividends if any.
If the investor had purchased ZYX at 44 1/4, and the stock did not move as he anticipated, the investor would have had two choices: sell the stock, and after commission costs, incur some losses, or hold onto it and hope that is rises over the long-term. Had he bought the options and he was wrong, the options would expire worthless and the loss would be limited to the premium paid.
