Buy A Call

A trader who thinks that a stock will go up can buy the right to purchase the stock (a call option) at a fixed price, instead of purchasing the stock itself. If the stock price at expiration is above the strike price by more than the premium paid, then he will make a profit. If the stock price is lower than the strike price, then he will let the option expire worthless, and lose only the amount of the premium.

Example

Suppose MSFT is trading at $46. A call option with a strike price of $46 expiring in a month is priced at $1. A trader’s assumption is that MSFT will rise sharply in the coming weeks and so he pays $100 to purchase a single $46 MSFT call option covering 100 shares ($1 x 100 = $100) with 30 days until expiration.

If the trader’s assumption is correct, and the price of MSFT stock goes up to $50 at option expiration, then he can exercise the call option and buy 100 shares of MSFT at $46. By selling the shares immediately in the open market at $50, the total amount he will profit from the exercise is $4 per share. As each option contract gives him the right to buy 100 shares, the total amount he receives when he sells the shares is $4 x 100 = $400. Since he paid $100 to buy the call option, his net profit for the entire trade is $300.00 ($400 - $100).

If the trader’s assumption is incorrect and the price of MSFT drops to $40 at option expiration, then the call option will expire worthless and his total loss is limited to the $100 paid to purchase the option.

Profit and Loss (P&L) at Expiration

If he had purchased 100 shares of MSFT at $46, that is, if he had purchased the stock outright, then his total investment would have been $4,600. With MSFT trading at $50, the investment would generate a $400 profit ($5,000 - $4,600 = $400). This is an 8.6% return on investment. Purchasing a call option, as detailed above, generates a $300 net profit, on a total investment of $100, or a 300% RoR (return on risk).