Call OPTIONS make money when stock prices rise


Call options are one of the two most important classes of stock options. The basic principle of trading these options is that if the price of the stock on which you buy an option rises, you make money.


HOW call options work

This class of option gives the buyer the right, but not the obligation to buy an agreed quantity of stock (usually in lots of 100 shares) at a specified price known as the strike price. The stock may be purchased from the seller of that option contract before the expiry date. This date depends on the duration of the contract. Purchasing the stock is known as ‘exercising’ the option.

Simply put, this means that you are entitled to buy the stock at the strike price at any time you wish up until the expiry date**, no matter what price the stock is trading at. The seller is obligated to sell you the stock at the agreed price, even if it is trading much higher than the strike price at the time you wish to purchase.

**Options on stocks in the American stock market may be exercised at any time up to the expiry date. Options on European stocks can only be exercised on the day of expiry.

BUYING CALL OPTIONS

To buy options, you pay a fee, or premium, to the seller of the options. This option premium is a fraction of the cost of the underlying stock, and rises or falls proportionally. For example, an option on a share with a market value of $25.00 may cost $1.20 per option. This would mean an investment of $120.00 to buy a lot of 100 options. There is also a commission which is paid to the broker of the sale.

When you purchase call options, you do so because you are expecting the price of the stocks to rise. The potential gain is large if the price of a stock rises well above the price you can buy it for (strike price). The profit that you can make is limited only by how high the underlying stock can rise within the period of the option contract.

If the price of the stock has risen to a price that is higher than the strike price, the option is said to be ‘in the money.’ To buy options with the potential of being in the money is one of the most basic and effective strategies for profiting from call options.

PROFITING FROM CALL OPTIONS

When you purchase call options, you do so because you are expecting the price of the stocks to rise. The potential gain is large if the price of a stock rises well above the price you can buy it for (strike price). The profit that you can make is limited only by how high the underlying stock can rise within the period of the option contract.

If the price of the stock has risen to a price that is higher than the strike price, the option is said to be ‘in the money.’ To buy options with the potential of being in the money is one of the most basic and effective strategies for profiting from call options.

risk with CALL OPTIONS

If the price drops, or fails to rise above the strike price, the risk is limited to the cost of the premium and commission. In this instance, you would obviously choose not to exercise the option. It would not make sense to purchase the shares at $25.00 from the seller of the option, when you could purchase those same shares for $23.00 in the stock market.

In deciding whether or not to sell an option that has dropped in value, you have to decide whether you believe that there is a good chance that the drop will be reversed within the time of your contract, or whether to cut your losses and recoup a portion of your investment on the premium rather than risking a bigger loss by holding onto the option.

Keep in mind that buying call options is not buying physical financial assets, but rather it is buying the right to future purchases.

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