The Benefits and Risks of Buying Call Options

When I began investing, first in mutual funds and later moving to individual stocks, I heard about stock options and wondered what they were.  Initially I thought that I was not experienced enough to deal with options and I worried about getting involved in something that I didn’t understand.  I’d heard about the ability to make a lot of money quickly, but I didn’t quite believe it.  As I continued to follow the stock markets, I realized that stock options are not complicated.  Simply put, options are a type of derivative security; they’re called that because their value is "derived" from the value of another security - in the example I use below, a particular stock.

I first got started in options by purchasing call options and I really didn’t understand the risks involved.  While there is a potential to use leverage and get a large return on your investment, the risks of losing most, or even all of your investment are significant, especially if you don’t understand what you’re getting into.

There are two types of options: "calls" and "puts".  You may have heard about other types of options, such as "spreads", "straddles" and "strangles", but these are simply different combinations of calls and puts.  Because describing the different combinations of options can get confusing fast, I’ll focus this article on buying call options.

What is a Call?

A call is simply a standard contract between two parties where the investor purchasing the call has the right, but not the obligation, to buy a certain number of shares (usually 100) of a particular stock at a specific price by a particular date.  In order to understand this better, let’s break it down:

  • A particular stock: This is called the underlying stock or sometimes just the underlying.  The value of the option is derived from the value of the underlying stock.
  • A specific price: This is called the strike price and is the price which the owner of the call will pay for the stock.
  • A particular date: This is called the expiration date.  One of the unique things about stock options and how they differ from stocks is that they expire.  The buyer of the call option has the right to exercise the contract to buy the underlying stock by this date.

How Much Money Can I Make or Lose?

So to explain this further, let’s use a specific example of purchasing a June 250 Netflix call.  (This is just an example to demonstrate the concept.  I’m not recommending this or any other specific option trades.)

If you purchase a June 250 Netflix call, you are purchasing the right, but not the obligation to buy 100 shares of Netflix at $250 per share before the third Saturday in June.  (Options usually expire on the third Saturday of a given month.)  You would have paid a certain amount for this right, say $9.20 per share or $920 total (since the option gives you the right to buy 100 shares).

I’ve included a profit/loss chart below.  Note that your breakeven point is when the price of Netflix is greater than $259.20 (the strike price of the option + what you paid for the option = $250 + $9.20 per share) by the third Saturday in June (the expiration date) to make money on the call option.  Your potential gain is theoretically unlimited.  Your maximum loss is limited to the amount you paid for the option.  If Netflix stock is less than $259.20 by expiration, you will lose money on the call option.  If Netflix stock is less than the strike price ($250) at expiration, the call option will be worthless and you will lose the $9.20 you paid for the call.  This makes sense - why would anyone want to exercise the call option and buy Netflix at $250 if they can go to the stock market and purchase Netflix stock for less?

Educate Yourself to be Successful

As you can see, there is a potential to make a lot of money, but there’s also the significant risk of losing everything you’ve spent buying the call options.  I didn’t understand this when I first started - I recall one trade where I bought a lot of calls for a particular stock, thinking that the stock would move up and I’d make a boatload of money.  It didn’t, of course, and I ended up losing my entire investment.  Learn from my lesson - if you want to trade stock options, educate yourself and take it slow.

Netflix Call Option Profit-Loss Chart(42458)
Credit: Generated in MS Excel