Options Trading: Buying a Call Option Explained.
As an introduction to options I would like to explain the terms or vocabulary used in option trading in a story or example instead of listing the definitions. I think we are trained by schooling to memorize lists of facts, but I think humans are storytellers by nature and learn best by stories. So I like to explain concepts using stories describing real world examples. We will start with a stock purchase and then review an option purchase. When you buy and sell stock it’s easy to calculate your profits buy subtracting your purchase price from your sales price. When buying or selling options you calculate your profit the same way.
For example if you buy 100 shares of Amazon for $100.00 each, and you sell them for $101.00 each, your profit for share is $1.00 multiplied by 100 shares, which equals $100.00 dollars profit. When you buy and sell options it’s the same, but the setup is slightly different, let’s explain by example.
First Example: Buy Stock:
Apple is 100$
You buy 100 shares at 100$.
Apple rises to 104$
You sell your Apple for 104$
Your profit is (104$-100$) times 100 shares) = profit
(104$-100$=$4) x 100 share= profit
(4$) x 100=400$ profit
Second Example: Buy Call Option:
Instead of buying Apple for 100$ per share and waiting for it to increase in price to 104$, you find someone who agrees to sell you their Apple stock at the price of 100$, in 30 days, if you still want to buy it in 30 days, and in return you pay them a fee of 1$ per share or 100$, to hold the 100 shares for you and honor the agreed on price of 100$ regardless of the market price.
So what you have done is purchase an “Option” which is “the right, but not the obligation”, to buy 100 shares, this number of shares is called “One Contract” of Apple at the agreed upon price of 100$, which called the “Strike Price” within 30 days, by paying a fee of 1$ per share, or 100$, which is called the “Premium”, and your agreement or “Option” ends or “Expires” in 30 days, which is called the “Expiration Date” or day that your agreement ends.
Second Example: Buy Option
Apple is 100$
You buy the options to buy 100 shares for 1$ per share or one contract at 100$.
Apple rises to 104$
You sell your Options for 4$
Your profit is (4$-1$) times 100 shares) = profit
(4$-1$=$3) x 100 share= profit
(3$) x 100=300$ profit
Now lets compare the two investments in terms of amount of money invested and what the return on the investment.
Investment equals 100 Apple shares at 100$ per share, 100 x 100$=10,000$.
Profit/Investment=return on investment
400/10,000=0.04, which is multiplied by 100 to calculate percent return. 100 x 0.04 is 4% return.
Investment equals 100 options at 1$ each.
100 x 1$=100$ invested.
Profit/Investment equals return on investment.
300/100=3, which is multiplied by 100 to calculate percent return, 100 x 3 is 300% return.
Now the First example made more profit.
But second example had a better return on investment.
As you can see, each investment required Apple stock to rise from 100 to 104$. But the first investment requires 10,000$ Capitol, while the second requires 100$ Capitol. But the first example provides an unlimited amount of time for the stock to appreciate for the profit to occur, while the second has usually 30-55 days and then the option expires and the total investment is lost.
This example illustrates the concept of leverage in options trading, which allows a small investment to allow the investor to profit from small moves in the stock price of relatively expensive stocks, with large returns on their investment. But the instrument used, an option has a limited life span.
There are advantages to each approach. Some consider stocks safer and thus options more risky. Others consider the size of the stock investment and thus limitations it may impose on your ability to diversify risky. It’s good to study these approaches and decide which approach is best for your money, after all you earned it, you should decide where and how to risk it.
I am predominantly an options trader, but own dividend paying stock for the same reason I hold Steem. I want my investment money to earn every day.
Now that we have defined these important terms in a story, let’s review the more traditional definitions and explanation.
An option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.
The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It's relation to the market value of the underlying asset affects the moneyness of the option and is a major determinant of the option's premium.
The amount of money per share you pay to purchase the option rights you seek, either to buy or sell stock share. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.
The Calender date that you rights to buy or sell end. An option is a temporary agreement with an end date agreed upon at the time of purchase.
A call option is an option contract in which the buyer has the right (but not the obligation) to buy a specified quantity of a stock or some other security, at a pre-determined price (strike price) until a pre-determined date (expiration).
For the seller of the call option it represents an obligation to sell the underlying security at the strike price, if the option is exercised. The call option seller is paid money (premium) for taking on the risk associated with the obligation.
Contract multiplier is a term you occasionally hear and for stock options, the multiplier is 100, which means each contract covers 100 shares.
✍️ By Shortsegments
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