Options trading may sound complex and difficult, and it is. In this article I aim to explain how profit can be made by buying long call options on stocks and how they work – I in no way mean to imply that doing so will probably or even have a chance of resulting in profit. Long call options are easier to understand in my view, and if you’re interested in learning about short calls or other types of options please explore on your own.
First of all, you need to find a broker (preferably one with a website and lower commission). You then need to set up your account for options trading – some brokerages require that you physically sign a document basically explaining that you understand the risks of trading options and what your experience level is etc.
There are options for from what I’ve seen all publicly traded stocks not excluding foreign ADRs. Call options can be defined as the option given to the purchaser of the option to buy a stock at a given price in the future. That given price is known as the ‘strike price’ and when the stock goes over that ‘strike price’ the option is said to be ‘in the money’ and the buyer of the option will most likely exercise the option.
For example, if a stock is currently trading at $3.50, the strike price is $6.00, and the option costs $0.50 a person can buy one option (a bundle of 100 stocks) for $50. Keep in mind buying the 100 shares of the stock normally would cost $350 at that same time. If the stock goes to $10 before expiration (the time at which the options can no longer be executed) the buyer of the option will willingly exercise the option and make $4 minus the price of the option ($0.50) per share which would be a $350 profit. If the stock did not go above $6 by maturity, however, the buyer of the option will get nothing. Keep in mind that usually call options get more expensive the farther out the expiration date is due to the risk of holding the stock on the writer’s side and the higher probability in general that the stock will rise above the strike price.
The person who writes the option believes that the stock will not reach $6 by expiration date and will have made $0.50 on every $3.50 stock in the 100 stock bundle in the option, not a bad way to make money on the share you own. The risk the seller (also known as the writer) of the option takes is that the stock goes below $3.00 (in which case the writer loses more than he gains by selling the option) or the stock skyrockets above the $6 level in which case the seller loses out on the profits of his stock because he is forced to sell it at $6. For the visual learner (most people) the chart below is a straightforward way of explaining how this works.