Buying puts can be an effective strategy to help protect your financial assets in a market downturn, however there are risks.
Long Calls: A Way to Leverage Your Investment
Buying calls is a popular strategy for novice and experienced option investors, in part because compared to other option strategies, it’s relatively easy to understand. Similar to stock ownership, you buy a call with anticipation that the stock price will increase.
The call option gives you the right, but not the obligation, to buy – for a cost (the premium)—an underlying stock at a specific price (called “strike price”) for a specific time (the expiration).
One reason you might purchase a call is to potentially profit from an increase in the price of the underlying security.
With a call option, if the security’s price rises above the strike price before expiration, you may be able to sell your option for more than you paid for it, or you can exercise the option and purchase the security for less than market value. However, if the price stays below the strike price through the expiration date, your option will expire as worthless and your loss will be equal to the purchase price of the option, plus trading fees.
Compare to Buying a Security
Buying a call option can be compared to buying a stock because you would utilize either one if you’re bullish on a security.
A major appeal of buying a call is that you're able to leverage your investment, with the possibility of realizing a higher percentage return than if you had made the equivalent stock transaction.
But unlike buying a stock outright, where someone can hold onto their investment for an unlimited length of time, an option contract expires after a certain period. Therefore, being right about your timing may be just as important as being right about the direction of the stock.
Long Call Example
Let’s illustrate how a long call might work:
If you purchase 100 shares of NRQ stock for $5 a share, you'll make an initial investment of $500. If, over the next year, the stock's price rises to $10 and you sell your shares, you'd make a $500 profit or 100% return (100 shares x $10 a share = $1,000 - $500 initial investment = $500 profit, or a 100% return).
Say, on the other hand, you had purchased 10 call option contracts with a strike price of $5 at 50 cents per contract on NRQ stock. Since 1 contract is typically convertible into 100 shares of a particular security, you would control 1,000 shares of NRQ for the same initial investment of $500 (remember, NRQ is trading at $5 a share). If the stock's price rises to $10 at expiration, the value of each contract would increase to $5 (the current stock price-the stock price when you initially bought the contract, compared to the initial value of 50 cents. If you sold at this point, the 10 contracts would have a $5,000 value (10 contracts x 100 shares per contract x $5 a contract) or $4,500 more than you originally invested – a 900% return.*
In addition, if NQR reaches the strike price, you have the opportunity to purchase the stock at the designated strike price, even if the price continues to rise higher. However, you should feel comfortable with owning that much of NRQ, and you need to have the funds available to make that purchase.
Risk: Let’s say the stock price of NRQ drops to $4.50 by expiration. In this scenario, you would lose 100% of the premium you paid for the call option, which was $500. Meanwhile, you would have lost just 10% of your initial investment, or $50 (excluding trading fees and commissions), if you bought the stock outright. Moreover, while you can wait for the price of NRQ to rise if you own the stock outright, you don’t have that same luxury if you purchase an option.
The breakeven point would come when the security appreciates high enough for you to recover your $500 premium. In this scenario, the share price would have to rise by 50 cents to $5.50 for you to break even.
In the graph shown here, the vertical (Y-axis) represents profit and loss, while the horizontal (X-axis) shows the price of the underlying stock. The blue line shows your potential profit or loss given the price of the underlying stock.
*Examples exclude transaction costs and tax considerations
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in the Scottrade Options Application and Agreement, Brokerage Account Agreement, by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation, or by requesting a copy from your local branch office. Supporting documentation for any claims will be supplied upon request. Consult with your tax advisor for information on how taxes may affect the outcome of these strategies. Keep in mind, profit will be reduced or loss worsened, as applicable, by the deduction of commissions and fees.
The information and content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
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