How To Leverage an Upward Price Move While Limiting Risk
At some point in our investing careers, we’ve all been there. You want to take advantage of an upward move in a stock, but don’t want to risk too much of your trading capital. Most beginner investors would simply leave it at that.
But for the rest of us, call options may be the answer.
A call option is a contract that gives the owner the right, but not the obligation, to buy 100 shares of the underlying stock at a specified price before a specific time.
Bullish traders typically 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. So will changes in other factors, such as volatility of the underlying stock.
If the stock becomes more volatile, for example, the call should go up in price. This is 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 and should decrease the value of the call.
In addition, 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.
Let’s further examine how traders use calls to leverage upward moves — while limiting their risk at the same time.
How Traders Use Call Options
A trader who is bullish on a stock, index, or ETF could buy a call option. As an example, let’s consider a fictional stock, XYZ corp.
If you think XYZ should continue going up in the next few weeks, you could simply buy the stock itself. Let’s say XYZ is trading near $200 a share. A position of 100 shares would cost $20,000. Instead of committing that much to the stock, you could buy a call option.
Let’s say you find a call option that allows you to buy 100 shares of XYZ for $200 (the strike price) at anytime in the next two months (the expiration is 60 days away). The call options trade for a price of $10.90 (the option premium). This would allow you to participate in any price rise for an investment of only $1,090.
If XYZ reached $230 a share at the expiration date, you would make $1,910. This assumes you buy the 100 shares for $200 and immediately sell them for $230. The premium of $1,090 is deducted from the profits.
Call traders can close their positions without having to buy the stock first and then sell it. Closing the position in this way (by selling a call) would lead to the same profit. In this scenario, you would make a return of 75% on your investment. If you had simply bought the stock, you would have made 15% on your $20,000 investment.
If XYZ closed below $210.90 on the expiration date, you would lose your entire investment. This is because buying and selling the shares would not cover the cost of the premium. However, your loss is limited to $10.90 per share no matter how far XYZ falls. To understand this, let’s say the stock falls to $166.67. If you owned 100 shares outright, you would lose $3,333. But as a call holder, you only lose $1,090.
The actual price move in XYZ would determine the price of the option. Calls can be bought or sold at any time and you would be able to take a profit or cut your losses at any time during the trade.
Why Call Options Matter To Traders
In essence, a call is a leveraged trade that allows the trader a chance to enjoy relatively large rewards for a certain amount of risk. This means call options can be a valuable part of an overall trading strategy.
If you want to increase profits or limit losses whenever you think prices will rise, then call options may be the answer. Traders who are bullish in the short-term can use calls to obtain long positions at a lower cost than buying the individual stock. Long-term options are available as well, and can be used to create low-cost, longer-term positions in a stock.
And if your capital is tied up in other ideas, or for whatever reason you don’t want to risk the full amount it would take to buy a meaningful stake, then call options are worthy of consideration.
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