Overview

Options are financial agreements between a buyer and a seller. An option is a contract that gives the owner the right, but not the obligation, to buy or sell an underlying asset on or before a specific future date. The owner can exercise the option or simply let it expire. Options are generally tied to stocks, futures markets, or commodities.

When an investor buys an option, they establish a contract with a seller. The contract establishes a specific price, called the strike price, at which the contract may be exercised or acted on. A contract also comes with an expiration date. When an option expires, it is defunct and no longer has any value. The investor has the option to use the contract, sell the contract, or to let it expire.

There are two basic types of options: put options and call options. Either can be bought or sold. Call options give the holder the right to purchase the underlying asset security at the strike price on or before the expiration date. In general, investors buy call options if they think the value of the underlying investment will rise in value. The contract locks in a specific price. The value of an option depends on whether or not it is in-the-money. A call option is in-the-money if the current value of the asset is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price.

Buying calls is one of the most straightforward and most popular option strategies. A call option enables an investor to lock in a low purchase price for a stock that may rise higher in the time specified in the option contract. Buying a call option offers potentially unlimited gain, carries limited risk, and is considered a solid investment during a rising market. When buying call options, investors bet that the underlying stock will rise by the time of the option's expiration date.

With call options, investors hold the right to purchase an equivalent number of underlying shares at any time at the strike price until the contract expires. If the stock price doesn't rise, then the contract can expire or be sold, and the investor simply loses the option premium or breaks even, rather than all of the money that would have been invested in purchasing shares. If the stock does rise, then little money was used to own rights to the stock.

Call options offer significant benefits from leverage. An investor who buys a call instead of purchasing the underlying stock maximizes the lower dollar cost of purchasing a call versus an equivalent amount of stock. There's much less cash outlay. The money not used to purchase all of the stock can be invested elsewhere.

The break-even point for buying a call option occurs when the underlying stock price rises above the exercise price plus the total cost of the premium and any fees paid. Every dollar above this sum represents added profit. The maximum risk taken is the amount paid for the option; if the option isn't in-the-money by the time of expiration, the call can expire or be traded or sold. If the stock rises above the option strike price, the amount of profit simply is the value of the stock less the stock price, less the option's premium.

With call options, there are three ways a contract can end: Let the call expire, forfeiting the premium plus any commissions paid; exercise the call at any time during the contract when the price of the underlying security is above the strike price, and then purchase the stock and sell it at the current market price, keeping the price difference, less the premium, as profit; or sell the call to another trader before the contract's expiration, cutting a loss, breaking even or making money if the price of the call has risen in value.

Buying call options usually works well as a strategy during a bull market, when most stocks tend to rise. Bull markets usually occur during economic recoveries or booms.