Options: Understanding Calls – making money when a stock price goes up

Setting up for future option strategy articles:
Last week I described put options. This article describes call options. I must establish what these two options are before discussing various strategies used by sophisticated investors to control and sometimes eliminate most risk from the movement in the price of a stock. Now, lets get into understanding what call options are.

What is a call option?
Options are a contract between a seller and a buyer on what specific price they will buy or sell the underlying stock. There are put and call options (I covered put options in last week’s article). When exercised, call options force the seller of a call to sell stock at a set price. As the buyer of a call, you hope the stock price goes higher than the call exercise price. If it does, then you can buy the stock at the call exercise price and sell at a higher market price or keep the stock.

A call (or put) option controls 100 shares of the underlying stock:
Critical things to know as an investor in options:
1) One call option controls 100 shares of the underlying stock. Therefore, when one call option is exercised by the call buyer, the call option seller must sell 100 shares of the underlying stock at a set price (an example below will help explain this).
2) Calls (and puts) are priced on a per share basis or 1/100th of the actual cost to buy or sell a call. So, if you see a call trading for $5, it will actually cost $500 to purchase that call option ($5 call option x 100 shares = $500 total cost). These two things can throw new option investors off until they get used to the leveraging inherent with trading options.
3) Call (and put) options on stocks expire at the end of the third week of the associated month. If not traded or exercised by the investor before then, it may expire worthless, or if there is still value in the option – the broker may exercise it automatically. Be careful to know your call option’s value on or before expiration day to prevent buying the stock automatically.

How can you make money with call options when the stock price goes up?
As mentioned above, a call option can be exercised to force the seller of the call to sell the underlying stock at a set price for the buyer of the call option if he/she chooses to exercise the option. The desire is to force the call seller to sell 100 shares of a stock to you at a lower price than the current market price you would have had to pay to buy the 100 shares of stock.

An example showing how a call option works and the associated leveraging potential:
For this simplified example, I will not include the fees charged by your broker to trade options or stocks.

I do research to find the stock of a company – xyz corporation – with a high probability of going up in price. On October 1st the price of xyz corporation stock is trading at $50 per share. I decide to purchase a November call option with a $55 strike price that expires the third week of November. This call is trading at $2 which means I pay $200 ($2 price x 100 shares of underlying stocks) to buy the call option.

By November 15th, the price of xyz stock rises to $70 and I tell my broker to exercise the option. The call option forces the call seller to sell these 100 shares to me at $55 each for a total cost of $5,500 ($55 x 100). I can then sell these 100 shares of xyz stock on the market for $7,000 ($70 price x 100 shares of stock) and have just pocketed a $1,500 profit ($7,000 – $5,500 purchase cost). However, I paid $200 for the call option so my net is $1,500 – $200 = $1,300. This is a 650% return on investment. In reality though the return would be less since there is usually a fee from the broker to buy the call option, buy the 100 shares of stocks, and to sell the 100 shares of stocks.

Another example showing the tremendous leveraging potential in options:
An alternative to exercising the stock purchase would be to sell the call option before it expires to another investor at a profit. If xyz stock is trading at $70 per share on my $55 call option, then there is a $15 profit potential for each of the underlying 100 shares of xyz stock. Keeping in mind the price quoted for a call option is in reference to a single share of stock, then the call should be trading closer to $15 and possibly more if the stock price is continuing to rise. That means I could sell the $2 call for $15 and pocket the difference. In that case, I will have paid $200 to buy the call ($2 call price x 100) and sold the same call now worth $15 for $1,500 ($15 call price x 100) for the same profit of $1,300 ($1,500 – $200). Again, this would be a 650% return on the $200 investment to initially buy the call. In reality, there would be a broker fee to buy the call and again to sell the call. However, you don’t have the extra fees of buying and selling the underlying 100 shares of stocks that would be incurred if the call option was exercised as in the previous example.

What is the potential loss with call options:
The main benefit of using call options to make money on stocks with dropping prices instead of shorting the stock is that your maximum loss of investment is limited to the total purchase paid to buy the call ($200 in the above examples). If the stock price never went higher than $55, then the call would expire worthless and the investor would loose the $200 investment.

The use of call options is another way of making money when the stock price is going up. They are especially good to consider when a stock has been unfairly beaten down in price and set to rebound. However, the price of such call option can be much higher since many investors likely expect the price to return back up and pay a premium for the option. You need to be careful since stock prices can change very quickly in the opposite direction causing your call to expire worthless. Don’t invest too much on calls in any one company. Diversify and use calls as one investment tool among many as part of your investment strategy.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.