Buying Calls (Long Calls)
There are some advantages to trading options for those looking to make a directional bet in the market. If you think the price of an asset will rise, you can buy a call option using less capital than the asset itself. At the same time, if the price instead falls, your losses are limited to the premium paid for the options and no more. This could be a preferred strategy for traders who:
Are “bullish” or confident about a particular stock, exchange-traded fund (ETF), or index fund and want to limit risk may want to utilize leverage to take advantage of rising prices. Options are essentially leveraged instruments in that they allow traders to amplify the potential upside benefit by using smaller amounts than would otherwise be required if trading the underlying asset itself. So, instead of laying out $10,000 to buy 100 shares of a $100 stock, you could hypothetically spend, say, $2,000 on a call contract with a strike price 10% higher than the current market price.
A standard equity option contract on a stock controls 100 shares of the underlying security.
Example
Suppose a trader wants to invest $5,000 in Apple (AAPL), trading at around $165 per share. With this amount, they can purchase 30 shares for $4,950. Suppose then that the price of the stock increases by 10% to $181.50 over the next month. Ignoring any brokerage commission or transaction fees, the trader’s portfolio will rise to $5,445, leaving the trader with a net dollar return of $495, or 10% on the capital invested.
Now, let’s say a call option on the stock with a strike price of $165 that expires about a month from now costs $5.50 per share or $550 per contract. Given the trader’s available investment budget, they can buy nine options for a cost of $4,950. Because the option contract controls 100 shares, the trader is effectively making a deal on 900 shares. If the stock price increases 10% to $181.50 at expiration, the option will expire in the money (ITM) and be worth $16.50 per share (for a $181.50 to $165 strike), or $14,850 on 900 shares. That’s a net dollar return of $9,990, or 200% on the capital invested, a much larger return compared to trading the underlying asset directly.
Risk/Reward
The trader’s potential loss from a long call is limited to the premium paid. Potential profit is unlimited because the option payoff will increase along with the underlying asset price until expiration, and there is theoretically no limit to how high it can go.
Buying Puts applies the same principles as above except the buyer is looking for downside moves instead of upside ones
The trader who buys 30 shares of AAPL common at $165 and one month later AAPL is trading below $165/share could sell for a loss or continue to hold. If AAPL is priced below $165/share on the day of the the call expiration the trader who still held 9 contracts would have $50 left of his original $5000 stake. if AAPL common were trading at $1.66/share on the call expiration date the holder who sells the common shares would have $98, a 96% larger stake than the call buyer.