Buy Call Option
Options in stock market are contracts that give the buyer a choice to sell or buy a stock at an agreed time in future at an agreed price. This is a right, which the buyer of the option may or may not exercise. In other words, it is not essential that the buyer exercise this right, as it is an option. Therefore, options can be effectively used to play in the stock markets, money markets, commodity markets, etc., without incurring unexpected losses. There are many such markets, and even economic situations such the interest rate increases, on which options can be traded and used to make monies.
Because the deal or contract relates to a time in future, options are known as futures contracts. Such contracts are actually derivatives because they do not involve purchase of the stocks, or money, or commodity, or other assets, per se, till the liability crystallizes. Therefore, in stock markets, the underlying instrument of these derivatives would be the stock, whereas in commodities markets, the commodities would become the underlying instrument. The terminology, however, is common in all markets. Such derivative trading is a recent introduction in markets, and has taken markets by storm especially because technology has also come of age. Therefore, such trading can occur in almost real time.
As the purchaser is acquiring the right to the choice (option), he doe not have to invest any monies other than paying the price for the right which is referred to as the premium. This premium is payable upfront. In conventional trading, the trader has to buy the stock by paying the price of the stock prevailing at a given time. This can be substantial, and it has to be paid upfront. But, in options trading, this is not so. Effectively, the required investment is low, and the loss, if it needs to be absorbed, is also limited to this premium amount. Premium is different from strike price; the other term commonly associated with options or futures transactions. Strike price is the price of the stock that the purchaser offers for the stock, and the seller (often referred to as the writer) of the stock accepts. Therefore, strike price is the expected price of stock that the two have agreed to buy or sell at, and therefore the price at which the deal has been struck. Options are of two types – call and put. In call option, the buyer offers to buy stock at a strike price at a future date that has been predefined.
In a call option, the buyer of the option would like the underlying asset or instrument to increase in price at a future date. Unlike him, the seller would want the opposite. Therefore, both are betting on opposite outcomes. If the price of the underlying instrument increases and touches the strike price, the seller or writer is obliged to sell the asset or the underlying instrument to the option holder at the strike price, but if the stock's price decreases or stagnates or does not reach the strike price plus the premium paid, the option holder can always back out from the deal. Therefore, buying a call option, when the stocks are moving up, or in bull market, would be ideal.
This can be understood more clearly with an example. Suppose a trader purchases a call option offering to purchase a stock (presently quoted at $1) after a month, at $1.5. The writer agrees to sell at that price at that time, and the trader incurs $0.25 towards the premium. If the price doesn't touch $1.5, the options trader may simply absorb the loss equivalent to $0.25, and walkaway. If, however, the stock price on that day touches $3, the options trader gets to purchase the stock at $1.5, and he can sell it for $3, or even less, recovering the premium paid, and making some profit in process. When the stock price crosses the strike price, and the option holder is clearly making money, the option is referred to as in the money.
Strategies used in call options may be long, short, or covered. The above example is that of a long call option. Short means selling a stock not in possession, but by borrowing it for now, with intention of purchasing at a future date. Therefore, shorting call option would imply that the trader will be purchasing the stock at a future date. In the same example given above, if the stock reaches $5 within the period of 15 days, the option holder does not have to wait for a month! He can sell the stock, because he is anyway entitled to purchase the stock at $1.5, giving him a profit of $3.25 after setting off the premium. This is called short selling the call option. Normally, however, call options are covered, which means, the trader already holds some stocks so that he doesnt have to use shorting strategy. This is because the trader might be considering expiry dates that may come in between. Covered options may involve a call and write combination, or overwrite method. Call option graphs are used to indicate the beak-even point, and from where the call option is in the mony. These charts are generated by the software programs that facilitate online trading. Even a novice playing in stock markets, using these strategies, and tools, can make money with call option.