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October 29, 2010 (Revised Ed.) - by Christopher Smith
  
Call Option Explained

A Call option provides the buyer with the right, but not the obligation, to buy the underlying security at the strike price.

Call options can be used in a variety of ways. The purpose of this article is to introduce you to some of the basic uses of a call option and how they can be used in your option trading.

Using A Call Option To Buy Stock

A call option vests the option buyer with the right to purchase the underlying security at pre-defined the strike price. That right is limited to a specified time period, defined by the option contract's expiration date.

On occasion you may be interested in buying stock, but you may be concerned about tying up a significant portion of your capital. Assume you are bullish on XYZ Corporation and you would like to buy 500 shares of stock. The current share price of $30 means that you would have to allocate $15,000 to the position. If using margin, you could make the purchase with just $7,500 in capital. You want to own the stock because you expect that it will move higher in price over the next several months.

An alternative approach to buying the stock is to purchase a call option, which allows you to benefit from upward price movement in the stock and, if you choose, to later acquire the stock. Assume you can buy an XYZ $30 Call option with six months left to expiration for $3.00. The capital requirement for this purchase is 10% of the current cost of the stock.

If your analysis is correct and the stock trades higher, you may exercise your rights under the contract and purchase the stock at $30 per share. You effectively enter the stock position with a built in profit.  On the surface this seems simple and straight forward, but in practice choosing an appropriate option requires a good working knowledge of options fundamentals.

Limiting Risk With Call Options

The maximum risk of your stock position in the above example is $15,000, regardless of whether you use margin or make the purchase in cash. A stop loss order can be used to limit risk, but it provides no guarantee that your order will execute at the designated price.

Buying a call option allows you to control the stock without taking on all of the risk associated with stock ownership. Your risk is limited to $1,500 ($3.00 * 500) or just 1/10th the exposure of owning the stock. No matter how far the stock price falls, you can never lose more than your original purchase price.  This is referred to as the "risk profile," which can be graphed.