Tuesday, April 04, 2006

Option Trading Basics --- Call Option

Call Option

“An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period.”

“It may help you to remember that a call option gives you the right to "call in" (buy) an asset. You profit on a call when the underlying asset increases in price.”
--- www.investopedia.com

The above definition for “Call Option”, or “Call”, probably is too abstract. Please let me give you an example to help you to understand this concept.

Let’s focus on stock only. Suppose there is a stock ABC. Its price is $20 as of today. If you, the “investor”, believe that the price of ABC will go up to $25 within 3 month, you could then buy a contract, the “agreement”, from a seller (“writer”, we would rather not discuss it now). You could choose your contact’s price, the “specified price” or strike price, at $25; and select the expiration date, the “specific time period”, to July, 2006.

Any option consists two parts: strike price and expiration date. The expiration date is represented as month and year. The exactly expiration date is usually the third Friday of that month.

Each contract represents 100 shares of stock. The real price of an option contract is the quote price * 100. In our example, suppose the quote of the call is $1, when you buy the contract, your total investment would be 1*100 = $100.

If you want to buy the stock for 100 shares, your investment would be 20*100 = $2000. Using the same money, you could buy 20 contracts that represent 2000 shares.

A call is the right to buy stocks at the agreed upon price during a certain time period. If the price is lower than the strike price, then no one would execution this contact. The contract could be expired.

Let’s say, when July came, the price of ABC is still $20. No one would execute this contact and buy the stock at $25. If someone really wants it, he/she can buy it at the market price $20. The $25 contact is worthless. You would loose your investment at $1*100 = $100, which is 100%.

If the price of ABC jumped to $30 in July, you can execute the contact and buy the stock at $25, and sell it at market price of $30. Your contract would worth ($30-$25)*100 = $500. It means you earned $400 or have 400% profit.

In our example, you can see that if price of ABC before the expiration date of July is below $25, then the contact is worthless; if the price is above $26, then we can make money; if the price is between $25 and $26, we would loss portion of our investment.

To buy a call option, your lost is limited which is your option cost; and your gain potential is unlimited.

In real situation, an investor would not wait till the expiration date to execute the contract. He/she would sell the contract earlier.

When you try to buy an option contract, it is called “Buy to Open”; when you sell your option, it is called “Sell to Close”.

To trade option, you need have your option trading enabled or have a separate option account. In either case, you need to fill out special forms. On the forms, you need show you have enough experience on stock trading. An option trading experience is a big plus for your account approval.

Good luck!


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