Options are derivative products that allow investors to leverage a high level of stock without having to come up with a large amount of capital and actually purchase the stock itself. Purchasers of call options can take advantage of stock moves without an equal amount of risk, and they can play out strategies that can fully realize the potential of a market upswing or protect against a downswing.
When an investor buys a call, he is purchasing the right -- but not the obligation -- to purchase 100 shares of a stock at a given price, known as the strike price. The premium, paid upfront, is the maximum potential loss that could occur even if the stock fell to zero.
The ability to leverage money by using options has resulted in different strategies using calls only. A common one is a "bull spread," in which an investor purchases a call with a lower strike price and sells a call with a higher one. For example, Mr. Smith bought an ABC December call for 35 and sold a December call for 40.
Breaking Down the Spread
The maximum gain or loss figured by a bull spread is easily calculated. If Mr. Smith bought a call on 100 shares of stock for a premium of $300 and sold a call for a premium of $100, he would be out $200. The maximum gain would be if the stock were called away at 40. In this case, Mr. Smith would gain $500 (40 – 35) minus the premium he paid, so $300 total. The maximum loss would be his initial outlay of $200.
Many strategies using options can get much more involved. By combining the use of calls and puts or buying and selling options, a maximum potential loss block can be created, thus reducing investor risk. Spreads and "straddles," which combine calls and puts to take advantage of potential volatility, are the two most common combinations, but many more types use different strike prices and dates.
- Options; O. Henry
- Understanding Options; Michael Sincere
Daniel Cross resides in Florida and has been writing investment and financial articles since 2005. He holds the Chartered Financial Consultant designation from the American College in Bryn Mawr, Pennsylvania.