Call Options – Too Risky For Most Investors?

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Call Options – Too Risky For Most Investors?

What is a call option?

A call option gives the owner the right, but not the obligation, to buy 100 shares of a specified stock at a specified price (the strike price) at any time before a specific expiration time (the expiration date). Investors use this as a bullish strategy and also as a leveraging strategy because the price of the call option will increase as the price of the underlying stock increases, and this gain will increasingly reflect a price increase in the value of the contractual stock when the market price moves above the option’s strike price before the option expires. Options offer great leverage because each option controls 100 shares of stock. It will cost $7,000 to buy 100 shares of a $70 stock but an option controlling that same hundred shares of stock could be purchased for several hundred dollars depending on the volatility of the stock and the amount of time before the options expires. The maximum amount that could be lost is the amount paid for the option instead of $7,000, the price to purchase 100 shares of stock.

Call options trade on an exchange just like stocks so there is plenty of regulation and plenty of liquidity. The Chicago Board of Options is the largest and well known option trading exchange. Most brokerage firms trade options for customers and firms like Options Express specialize in option trading for their customers. Commissions are a very important component of option trading. Most large firms have a minimum $35 commission per transaction. So for example if you bought 3 options for $200 each, your total investment would be $635. The $35 commission would be 5.8% of the purchase price, so to break even on this trade the investor would have to make over 10% just to cover the commissions. Online trading firms offer much lower commissions such as $10 per trade so they are more economical but they do not offer as much research and guidance. The more call options that are purchased per transaction lowers the percentage cost of the commission on the transaction.

Who Should Consider Buying a Call Option?

A trader who is very bullish on an individual stock and wants to profit from a rise in its price.

An investor who would like to gain from the huge leverage that options can provide, and wants to limit the amount of funds they have to invest and risk.

An investor who forsees an increase in value of an individual stock but does not want to commit all of the funds needed to purchase the individual shares.

Buying call options is one of the easiest and most popular strategies used by option investors. It allows an investor the opportunity to profit from an increase in the price of the underlying stock, while having less capital at risk than with the outright purchase of an equivalent number of underlying shares, usually 100 shares per call contract.

The profit potential for the long call option is unlimited as the underlying stock continues to rise. The financial risk is limited to the total premium paid for the option, no matter how low the underlying stock declines in price. The break-even point is an underlying stock price equal to the call’s strike price plus the premium paid for the contract. As with any call option, an increase in volatility has a strong positive effect on the long call price while decreasing volatility will have a negative effect. Since options have expiration dates, the closer the call option gets to expiration the more negative the effect on the price of the option.

Buying call options is very risky because they are time sensitive and the total investment can be lost. It is important to be educated about the risks and rewards of option trading.

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