Buy Call Option Example

Let say we think XYZ stock is going to go up to $100 in 1-2 months time and the current stock price is $88.00 at the beginning of OCT 2009. Instead of buying the stock, I can buy a Call option of XYZ to benefit from the raise in stock price. So we are buying a XYZ Call Option with a strike price of $90.00 and expiry at DEC 2009 for a premium of $4. The benefit of purchasing the option instead of the underlying security is leverage. If we buy the stock for $88 and sell it for $100, we are talking about 13% return on investment (ROI). But if we use $4 to purchase the option and the stock price reach $100 anytime from now to expiry. We can either exercise our right to buy the stock for $90 and sell it to the market for $100. So our ROI will be 100-90-4 = $6 which is 150% return on our initial investment. Or we can also choose to sell our Call option to the market. If the stock is trading at $100, our Call option with a strike price of $90 should have an intrinsic value of $10. Which mean we should be able to sell it for $10 at least excluding time value. And our ROI will be 10-4= $6 which is also 150%.So in this case, we are talking about a ROI of 150% VS 13%. This is the main reason why people would purchase a Call option instead of shares.

Article by
Trading Room
www.tradingforreal.blogspot.com