How To Leverage an Upward Price Move While Limiting Risk
A call is an option contract that gives the owner the right, but not the obligation, to buy 100 shares of the underlying stock at a specified price (which is known as the strike price of the call) at any time before a specific time (the expiration date of the call).
Bullish traders would use calls because the value of the call should increase if the price of the underlying stock goes up. The potential profits for a trader owning a call are unlimited since the underlying stock can go up to any price. The maximum possible risk on a call is limited to the total price paid for the option contract.
Changes in the price of the underlying stock will lead to a change in the value of the call, as will changes in the volatility of the underlying stock. If the stock becomes more volatile, the call should go up in price because there is a greater chance that it will reach the strike price by the expiration date. Falling volatility decreases the chance that the underlying stock will rise that much and should decrease the value of the call.
In addition to being driven by the price and volatility of the underlying stock, the call will also change in value based on how much time is left before the expiration date. The call will be less valuable as it gets closer to the expiration date.
How Traders Use It
A trader who is bullish on a stock or index could buy a call. There are also option contracts available on some ETFs and futures. Traders can use calls on a number of individual stocks, indexes like the S&P 500, or ETFs like the SPDR S&P 500 (NYSE: SPY). A call is a leveraged trade that allows the trader a chance to enjoy relatively large rewards for a certain amount of risk.
As an example, consider Apple (Nasdaq: AAPL). If AAPL is trading near $200 a share, 100 shares would cost $20,000. Instead of committing that much to the stock, if a trader thinks AAPL should continue going up in the next few weeks, they could buy a call option that allows them to buy 100 shares of AAPL for $200 (the strike price) at anytime in the next two months (the expiration is 60 days away) for a price of $10.90 (the option premium). This would allow them to participate in any price rise for an investment of only $1,090.
If AAPL reached $230 a share at the expiration date, the trader would make $1,910. This assumes they buy the 100 shares for $200 and immediately sell them for $230. The premium of $1,090 would be deducted from the profits.
Call traders can close their positions without having to buy the stock first and then sell it, and closing the position in this way (by selling a call) would lead to the same profit. The options trader would make a return of 75% on their investment. A trader buying 100 shares of AAPL would make 15% on their $20,000 investment.
If AAPL closed below $210.90 on the expiration date, the trader would suffer a loss of their entire investment since buying and selling the shares would not cover the cost of the premium. However the trader’s loss is limited to $10.90 per share no matter how far Apple falls. If the stock falls to $166.67, the owner of 100 shares would lose $3,333 while the call holder would only lose $1,090.
The actual price move in AAPL would determine the price of the option. Calls can be bought or sold at any time and the trader would be able to take a profit or cut their loss at any time during the trade.
Why It Matters To Traders
Calls can be used as part of a trading strategy to increase profits or limit losses whenever a trader thinks prices will rise. Traders who are bullish in the short-term can use calls to obtain long positions at a lower cost than buying the individual stocks. Long-term options are available and traders can use them to create low-cost, longer-term positions in a stock.
(This article originally appeared on ProfitableTrading.com.)
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