In part one of our series on understanding stock options we discussed some general definitions.  Now we will take a look at the purchase of a call option.  There are two basic principles to stock options: rights and obligations.  With some options you will have a right while others you will have  an obligation.  Let’s take a look at the purchase of a call option.

Purchasing a Call Option

A call option is the right to purchase a stock at a certain price known as the strike price.  You purchase this option which gives you the right to buy that stock for the specified strike price.  There are also several different months out in the future for up to about two years to choose from.

For example XYZ Company’s stock is trading at $10 and it is June.  You can buy a call option to purchase that stock at $11 in August for 25 cents.  So what you have done here is paid 25 cents in June for the right to buy XYZ Company in August for $11.

Just because you have the right to buy this stock does not always mean you will exercise your right.  In order for you to break even, the stock in XYZ Company must be trading higher that the strike price ($11) plus the cost of the option (25 cents) or $11.25.  Otherwise you could just purchase the stock in the open market for cheaper.

Examples of How a Call Option Purchase Works

Let’s look at two examples of how the purchase of a call option could transpire when it gets to August:

1-     XYZ Company is trading at $10.  In this case you would do nothing with your call option.  You would not exercise your right to purchase the stock because you would not want to pay $11 for a stock that you can buy for $10.  All you are out on this transaction is the 25 cents that you paid for your option.  It will just expire worthless.

2 -  XYZ Company is trading at $15.  You will definitely want to exercise your right to purchase the stock because you can purchase it for $11 and instantly sell it for $15.  Your profit would be the sale price of the stock ($15) less the purchase price you paid for the stock ($11) less the cost of the option (25 cents) or $3.75.

As you can see you can make a lot of money with a call option as well as lose your entire premium.  Call options are an inexpensive way for a small investor to participate in the upside potential of a stock without having to have the outlay of purchasing the stock at full price.