The concept of Call Options: American style Call Options are legally binding contracts that grant the buyer the right to buy 100 shares of the underlying stock, at a fixed predetermined price. This right comes at a cost, known as the premium of the Option, and the buyer can exercise this right or sell it back to the market any time before expiration. The buyer of the Call Option expects the underlying stock to rise in price, so that he can sell his Call option back at a higher premium, or exercise his right and buy 100 shares of the underlying stock at the lower, agreed price and then either hold on to the investment or sell the stock back to the market at the new higher stock price.
Payout diagram of the Call Option
When you buy a Call Option your risk is limited to the premium paid, the above chart indicates a Call Option with a premium of $200, that is all that can be lost if the stock fails to rally. The above chart shows what happens at expiration, when the Option premium consists of intrinsic value only!
Why do people engage in Call Options trading:
Call Options offer significant leverage, and also offer a better risk – reward ratio, in general you can easily make 40% profit on your capital even though the underlying stock only moves 5%. The better risk – reward ratio is only found in the more expensive in-the-money Call Options, that is Call Options whose predetermined contract price (Or strike price) is lower than the price of the stock. This means that you stand to win more as the stock moves in your favour but you also stand to lose disproportionately less if it does not move in your favour. This is something that is unique to Options, no other trading vehicle has asymmetrical pricing structure.
In a typical Call Option trade that goes well, you can make 40 – 50% within 2 days, just by choosing the right stock, one that will move 4 – 6 % over that period of time. For example you can buy an $800 Call Option on a $100 stock, if the stock rises to $105, your Call Option will be worth $1,350 to $1,400. If the stock drops instead to $95, your Call Option will be worth around $550. That is either winning $400 or losing $250, but you have to be careful how you choose your Call Options, many different Options are offered on every Optionable stock, each comes with a different expiry date and strike price.