What is an Option?
An option is a contract to buy or sell a specific financial product officially known as the option'sunderlying instrument or underlying interest. For equity options, the underlying instrument is astock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. Itestablishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and nolonger exists.Options come in two varieties, calls and puts, and you can buy or sell either type. You makethose choices - whether to buy or sell and whether to choose a call or a put - based on what youwant to achieve as an options investor.
What Are Call Options?
A call option is a contractual agreement between a buyer and seller which gives the right, but notthe obligation, to the buyer to acquire a specified number of shares in a security at a predefined price (strike price) within a predefined amount of time. Eachoptionscontract represents 100shares in the underlying security; for example, 10 Apple July 09 $125 call options will allow theholder of the call option to purchase 1000 shares of Apple at $125 on or beforeoptionsexpiration week in July 2009.Call options can be bought, sold, and even shorted. They are predominately used for purposes of hedging but many traders will use them for speculative purposes as well. For example, the most popular hedging strategy using calls is known as acovered callstrategy. Traders will short callsto offset a portion of the downside risk of a stock that they own or lower the net cost of purchasing the stock. Conversely, a speculator may sell a call option without owningtheunderlying security. This is known as a "naked" call and carries an unlimited risk.Remember, you are basically selling another trader the option to buy a stock at a certain price;therefore, the higher that the underlying moves, the more money you lose.You can generally say that the price of a call option moves higher as the stock moves higher andvice versa. The risk of buying a call option is merely the amount of money that was paid for theoption. The upside profit potential of a long call option is unlimited.
Advantages of Call Options
Buying call options introduce two distinct advantages to a trader. First, they provide traders witha large amount of leverage. In our Apple example above, assume that the call was trading at$10. Therefore, the buyer would have to pay $10,000 ($10 * $120 * 10) to control 1000 sharesof Apple which currently trades at $120. You can see there is a 10 times leverage factor in this