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Here's how call options work.

When looking for a smart investment strategy, some investors buy call options. Call options often enable investors to maximize profits while minimizing risk. Purchasing a call option may yield profit that is significantly higher than if you bought a security outright. However, as with any investment strategy, there are risks involved.

Understanding call options and how they work can help investors make savvy investment decisions. Here’s how to determine if this investment strategy is right for you.

What Are Call Options?

Call options give investors the opportunity, but not the obligation, to purchase a stock, bond, commodity or other security at a certain price, within a specific time frame. The sellers must let the buyers exercise this option. The buyer of a call option must pay a premium for the privilege of having the choice to buy the security at a predetermined “strike price” on or before a specific date.

It makes sense for an investor to buy a call option if the stock price rises above the price in the option. This means that the investor is able to buy the stock at a discount. On the other hand, if the stock price dips below the option price, it may not make sense for the investor to buy.

The main reason an investor would want to buy a call option is to capitalize on the upside of owning a stock while minimizing the risk. For instance, if you had the opportunity to either buy 100 shares of stock for $60 per share or a call option and purchase the stock at a discount, wouldn’t it make more sense to do the latter?

Characteristics of Call Options

When selecting a call option, you have several decisions to make before purchasing one. Understanding the elements of call options is crucial when deciding if they are a suitable investment strategy for you. Here are some of the options you can choose from.

  • Security. If you predict security ABC is going to increase in value in the near future, you may want to buy a call option.
  • Trade amount. The trade amount is the maximum amount you want to spend on a call option transaction.
  • Number of contracts. When you buy a call option, you will need to decide the number of shares you would like to purchase.
  • Strike price. Regardless of what the current stock price is, an owner of a call option can decide at what strike price they want to purchase the security. For example, if they want to purchase ABC stock for $60 per share, the call option is only exercised when the stock price reaches that amount.
  • Call options price. The purchase of call options involves a premium amount for completing the trading transaction. If the premium is $2 per share and the call option is for 100 shares at $60, the investor would pay a $200 premium for this transaction.
  • Expiration date. Investors have the choice to select an expiration date for the contract. This means that if the price doesn’t hit their call option amount by the selected date, the request expires.
  • Type of order. Investors can also select a type of trading order. For example, an investor can select a limit order, which allows the investor to buy or sell a stock at a certain price.
  • Put option. The opposite of a call option, where investors place an order to sell their shares at a certain price within a certain time frame.

How Call Options Work

Here's how call options work.

To illustrate how a call option works, let’s use the example above. If a stock is trading at $60 per share, you may predict that the price will rise in the near future. While you could purchase 100 shares by paying $6,000, you could also buy a call option that would allow you to buy the stock at $63 per share within the next two months. This option could cost an investor a premium of $1.75 per share or $175, based on the current state of the market.

If your prediction is correct, and the stock price rises to say $83 per share, then both investment strategies may result in a similar outcome. The first strategy, to purchase the stock outright, would mean your investment would be worth $8,300. This outcome yields a profit of $2,300. The other strategy, to buy the call option at $63 per share, would result in a $2,000 profit. You’d need to subtract the $175 premium to determine your gross profit from the call option investment.

However, if the stock price skyrocketed, to say $103 per share, an investor could make upward of $4,000, minus the premium for the call option transaction. If the investor didn’t purchase the stock when it was at a lower price, they may have missed their opportunity to profit. Therefore, the stock option allowed them to capitalize on the rising price of the stock.

You can purchase a call option through an online brokerage account or on a variety of exchanges. However, you must first be approved, which is based on the level of experience and amount of knowledge with options trading.

Disadvantages

The downside of buying a call option is if the stock price only increases a bit, you could actually lose money on the investment. For example, if the stock price from the example above only rose to $63, and you bought 100 shares outright, you would profit $300. If you bought a call option of $63 per share you would make the same $300, but lose $175, which was the cost of the premium associated with buying the call option. This means you’d really only profit $125.

However, the real value of call options is to minimize the risk of an investment. If you were to buy a call option and the stock price went down, you would save yourself from losing money. If you bought the stock outright for $60 per share and the price dropped to $40 per share you would lose $2,000. Purchasing the call option would only cause you to lose $175. The risk of the call option is always capped at the price of the premium. So even if the stock price doesn’t rise at all, you may still need to pay the premium, which technically means you’d lose money.

The Bottom Line

Here's how call options work.

While call options may seem like a savvy investment choice, all investment strategies have a different level of risk and reward. Investors should consider each type of investment before determining which decisions make sense and align with their goals.

Tips for Investors

  • It’s wise to consider working with a financial advisor who can help you evaluate your investment objectives and aid you in the creation of your own investment strategy. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • While investing your money is an exciting way to potentially grow it, it’s important to ensure your other finances are in order. Before investing, consider building an emergency fund with at least six months’ worth of expenses saved. Also, consider reevaluating your retirement saving strategy to ensure you’re all set for your future. Lastly, don’t forget to pay down your debt to save even more money in the long run.

Photo credit: ©iStock.com/matejmo, ©iStock.com/wutwhanfoto, ©iStock.com/oatawa

Ashley Chorpenning Ashley Chorpenning is an experienced financial writer currently serving as an investment and insurance expert at SmartAsset. In addition to being a contributing writer at SmartAsset, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.
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