Call Options: How To Make Money In An Up-Market
Call Stock Options or Call Options, the right to buy 100 stocks, is designed to make money when the underlying instrument (stock) go up in value.
Also, it can lose money when the stock goes down. The easiest way to explain the way a call option work is to relate it to the real estate market.
Most people are familiar with it they should not have any problem.
Say if you want to invest in a $500,000 piece of real estate for capital gain,(expecting the price of home will go up, says 10% in the next one year), there are 2 ways you can purchase it.
One is pay in full – $500,000, anotheronly 5% of the price – $25,000 for right to buy the home one year from now.
Suppose that you are right and one year later, the value of that home went up 10% and now value at $550,000.
If you paid in full $500,000, your return on investment is only 10% – $50,000.
However, if you paid only $25,000, your return would have been 200%. That’s exactly how a call option works in the stock market but you have more choices of when to purchase the stocks.
However, in case of a real estate market crash and the value of that home went from $500,000 to $100,000, you have the right to walk away from that Call Options, accepting a loss of $25,000.
You don’t have an obligation to buy that home and suffer a 80% loss in value. A Call option give you right to buy the stocks at certain price but not obligation to buy it in case the stock go south.
The illustration is a risk graph of a 48days to expire, 27 strike call options on EBAY. If you buy this call option, you have 48days to be right on the upward direction.
One call options of EBAY (to control 100 EBAY stocks) costs you $1.10 and translated to $110 to control 100 stocks.
By the expiration date, if you EBAY didn’t move or go down below $26.57, you would lose all your $110.
If it moved to $28.09, you only breakevens because stock only moved the cost of the options purchased.
However, if EBAY moved to 28.09 in one day, as shown in the graph, you would make ~ $85 on your $110 investment.
Not bad for a $1.5 move in stock price huh.
There is no limit to how high a stock price can go so you can make a lot of money in the lifespan of the option providing you are right on the direction.
Call options limits your risk to the cost of the purchased options while giving you unlimited rewards to the upside.
Category: OPTIONS BASICS
