Call Options 101
Options, while complex and sometimes difficult to understand, play a major role in the global financial system. Used for hedging and speculation, options offer a low risk means to building a position. Let’s explore the call option; one of the most commonly used options. A call option allows someone to buy a certain amount of something, say shares of stock, at a certain price within a certain amount of time. In essence, it's a contract without an obligation. The basic components of a call option include the following:
Strike price: the price at which a share of stock can be purchased
Expiration: the date at which the option expires
For example, company ABC January 15 calls allow the holder to buy a share of ABC stock at $15 any time between now and January. Of course, this comes at a price which is known as the option premium. The option premium is based on the amount of time until expiration, the current stock price, and the volatility of the stock price among other things. Suppose ABC stock sells at $15 per share and the Jan $15 call option sells for $2. You could buy the call option for $2 and when the stock moves above $17, you've made money. If the stock is below $15 at expiration, you've only lost the $2 premium paid for the option. In other words, your maximum loss is limited to the premium paid and your maximum gain is unlimited.
Call options sound almost too good to be true. Unlimited upside with limited risk sounds pretty good, right? Here's the big problem with options: they expire. If your option expires worthless, you've lost your entire premium. If, on the other hand, your stock price is below what you paid, you can always hold onto it and hope that at some point in the future it recovers. Your stock loss is only a paper loss whereas your option loss at expiration is a real one.
Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.