|
 For
example purposes we'll say you have a strong
feeling a particular stock is about to move
higher. You can either purchase the stock,
or purchase 'the right to purchase
the stock', otherwise known as a
call option. Buying a call is similar to the
concept of leasing. Like a lease, a call
gives you the benefits of owning a stock,
yet requires less capital than actually
purchasing the stock. Just as a lease has a
fixed term, a call has a limited term and an
expiration date.
Example: Let's look at an example
option. Microsoft (stock symbol:
MSFT) is trading at $55.00, it would
take $55,000 to buy 1000 shares of the
stock. Instead of purchasing the stock you
could purchase a MSFT "call option" with a
strike price of 55 and an
expiration 1 month in the future. For
instance, in May you could Buy 10
MSFT JUN 55 Calls for $2.50. This
transaction will enable you to participate
in the upside movement of the stock while
minimizing the downside risk of purchasing
stock.
Since each
contract controls 100 shares, you bought the
right to purchase 1000 shares of Microsoft
Stock for $55 per share. The price, $2.50,
is quoted on a per share basis. As such, the
cost of this contract is $2500 ($2.50 x 100
shares x 10 contracts).
|
MSFT
Trading at $55.00 |
|
Buy |
10 MSFT JUN 55 Call |
$2,500 |
|
|
Cost
of trade |
$2,500 |
If the stock stays at or below $55 before
the options expire, $2500 is the most you
could lose. On the other hand, if the stock
rises to $65 at expiration, the options will
be trading around $10 (current price: $65 -
strike price: $55). Thus, your $2500
investment will be worth $10,000 ($10 x 100
shares x 10 contracts).
If the stock
price increases, the option gives you two
choices: sell or exercise the call.Many
investors choose to sell because it avoids
the substantial cash outlay involved in
exercising your call option. In the example
above, to exercise you
would pay $55,000 ($55 x 1000 shares) to buy
the stock when you exercise the options. At
a market price of $65, your shares would
actually be worth $65,000. Not including
commissions, you would have made a $7,500
profit on your $2500 investment ($10,000 -
$2500).
Compare this
to selling the options: you realize the same
profit without spending the money to buy the
shares. With the stock at $65, the
Jun 55 calls would be worth $10 per
contract. Thus, each option contract would
have a value of $1,000 ($10 x 100 shares *
10 contracts). Not a bad return for a $2500
investment!
The scenario
described above is a great example of the
leverage that options provide. Just look at
the returns on a percentage basis.
|
|
Purchase $ |
Sale $ |
Profit |
% Gain |
|
Stock Price |
$55 |
$65 |
$10 |
18.2% |
|
1000 Shares |
$55,000 |
$65,000 |
$10,000 |
18.2% |
|
10 Jun 55 Calls |
$2,500 |
$10,000 |
$7,500 |
300% |
As the
chart above demonstrates, if you
bought 1000 shares of stock at $55,
you would be putting $55,000 at
risk. If you sold the stock when it
rises to $65, you make $10,000 on
your $55,000 investment, a 18.2%
return. In contrast, investing $2500
in call options only puts $2500 at
risk. In this case, the return is
300%.
Now,
let's see what happens when the
stock drops.
|
|
Purchase $ |
Sale $ |
Profit |
% Gain |
|
Stock Price |
$55 |
$45 |
($10) |
(18.2%) |
|
1000 Shares |
$55,000 |
$45,000 |
($10,000) |
(18.2%) |
|
10 Jun 55 Calls |
$2,500 |
$0 |
($2,500) |
(100%) |
While
this scenario looks scary on a
percentage basis, when you look at
the raw numbers, it's clearly
relative. If the stock drops, your
calls may expire worthless, but your
loss is limited to your initial
investment, in this case $2,500. In
contrast, the stockholder sustains a
far larger dollar loss of $10,000.
When you compare the limited
downside and the unlimited upside
potential of call options, it easy
to see why they are such an
attractive investment for bullish
investors.
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