Why Traders Buy Call Options
This article should not be construed as investment advice. It is a hypothetical illustration of why someone would buy a call option as opposed to buying a stock. Options involve substantial risk and are not suitable for everyone. Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). It explains the characteristics and risks of exchange traded options. It can be obtained here: http://www.optionsclearing.com/about/publications/character-risks.j
Earlier this week, I was watching the Twitter (TWTR) sale saga play out. At the time, Salesforce.com(CRM) was rumored to be the main suitor for the company. The drama that ensued was that Salesforce.com (CRM) stock began to sell off as the price tag ($20 billion) for Twitter was considered to be too dilutive to earnings.9
The stock went down below 67 at one point. Given the fact that Salesforce.com (CRM), in my opinion, has a dominant presence in their business and has been growing, my opinion was that this was a good time to buy some of it at a discount. The fact that the sell off was event driven made me think that a quick profit could be in store.
At that point, I can buy the Salesforce.com (CRM) stock or buy a call option on it. The call option gives me the right to call the stock away at a given price up until a certain date, when the option expires. To purchase ten option contracts, which gives you the right to control 1000 shares of stock, the cost was $1,697.
If I decided to buy the stock, it would be approximately $67,000. The issue here is that I’d prefer to tie up as little capital as possible and I wasn’t looking to purchase the stock at that time.
So, do I pay $1,697 to participate in the upside if the stock for a short period of time or do I buy the stock for $67,000 which I could theoretically hold forever?
Hypothetically, lets just say I decide to buy the call. At 9:53 AM on 10/5/16 I could have bought 10 Salesforce.com (CRM) Call Options expiring Nov 18 2016 with a strike price of 72.5. The total cost to buy these options would be $1,697.74. This means that for $1,697.74, I purchased the right to call the stock away if it is worth 72.5 or more. this option expires on 11/18/2016.
A few things can happen:
1.) The option can expire worthless on 11/18/2016. This would happen if the price of the stock isn’t equal to or greater than 72.50 ( aka”strike price”). At this point we would lose our entire investment of $1,697,74.
2.) If the stock moves toward 72.50,the option will become more valuable given the higher probability that it will not expire worthless. In this scenario, I could sell the option itself for a profit. (more than the $1697.74 we bought it for)
3.) If the stock is above $72.50, we can “call it away” from the person who sold us the option. At that , we point would own 1000 shares at 72.5 purchase price. This would be great if the stock were to go to , say, 75.
For the sake of this example, lets say scenario #2 plays out. We will sell the option at a profit.
At 9:41 AM on 10/6 , we could have sold the option we bought less than 24 hours earlier for $3,042.19. This equates to a profit of $1344.45. That’s a profit of 79.19 % in less than 24 hours
What if we had bought the stock? Let’s say we bought it for 67 and sold it at 71. That’s a profit of 5.97%. Still a great return but you can see the power of the call option and the leverage it affords.
This article should not be construed as investment advice. It is a hypothetical illustration of why someone would buy a call option as opposed to buying a stock
Options involve substantial risk and are not suitable for everyone. Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). It explains the characteristics and risks of exchange traded options.
It can be obtained here: http://www.optionsclearing.com/about/publications/character-risks.jsp