Publication date: March 29, 2024
Options are versatile financial instruments that allow investors to profit from price changes without having to buy or sell the underlying asset directly. In this guide, we focus on the call option, a widely used instrument for investors speculating on price increases. Below, we explain step by step what a call option is, how to buy and trade it, and the benefits and risks involved.
What is a Call Option?
A call option gives the buyer the right, but not the obligation, to buy a certain underlying asset, such as a stock, at a pre-agreed price, known as the strike price, within a specific time frame. The main advantage of a call option is that you can profit from price increases without owning the underlying asset. This allows you to achieve a potentially large return with a relatively small investment.
How Does Buying a Call Option Work?
When you buy a call option, you pay a premium to the seller of the option. This premium is the amount you risk in the transaction. You have the right to buy the underlying asset at the agreed strike price if the price rises. The option has a limited duration; if you do not exercise the option before the expiration date, you lose the paid premium.
Example: Suppose stock ABC is currently trading at €50. You expect the price to rise in the coming months and decide to buy a call option with a strike price of €55 and a premium of €3 per share. If the price of ABC rises to €60 within the option’s duration, you can buy the stock for €55 and immediately sell it for €60, resulting in a profit of €2 per share (the profit is the selling price minus the strike price and the premium: €60 - €55 - €3). However, if the price does not exceed €55, the option expires worthless, and you lose the €3 premium.
Advantages of a Call Option
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1. Potential High Profit: In the event of a price increase, you can make significant profits even with a small investment. This is because you only pay the option premium, not the full value of the stock.
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2. Limited Loss: The maximum loss is limited to the premium paid. Even if the stock price does not rise, your loss is capped at this amount.
Risks of a Call Option
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1. Time Decay: Options have an expiration date. If the stock price does not rise quickly enough, the option may become worthless, and you could lose the entire premium.
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2. Unexpected Price Movements: If the stock price does not increase as expected, or if it drops, buying a call option can result in a loss.
Types of Options
In addition to call options, there are put options, which give investors the right to sell an underlying asset at a predetermined price. This instrument is typically used if you expect the stock price to decrease. Call options are ideal when you believe the price will rise, whereas put options profit from price declines.
Buying and Trading Options
To start buying options, you first need to open a brokerage account with a broker that trades options. Then, you research the options you're interested in, such as analyzing the expected direction of the price of an underlying stock. It’s essential to understand the strike price, expiration date, and premium before purchasing an option contract.
Options trading can be done in different ways depending on your strategy. Investors can buy options expecting price increases (with call options) or price decreases (with put options). Additionally, there is the option to write (sell) options, where you receive the premium but accept the obligation to buy or sell the underlying asset if the option is exercised.
Conclusion
Call options offer investors the opportunity to profit from price increases without directly owning the underlying asset. They can be a powerful tool in a well-thought-out investment strategy, but it's crucial to understand the risks, such as time decay and unexpected market movements. If you'd like to learn more about options, follow our analyses and articles for a better understanding of these complex but rewarding investment instruments.
Disclaimer: Investing involves risk. Our analysts are not financial advisors. Always consult an advisor when making financial decisions. The information and tips provided on this website are based on our analysts' own insights and experiences. Therefore, they are for educational purposes only.
