Option strategies can be complex when used in combinations, so we will focus on just using the call option to supplement your investment strategy.
What are call options?
Options are a popular form of leverage used by retail investors who want to give their portfolio a boost, but don’t want to carry the risks involved with borrowing money. Call options utilize risk-adjusted leverage that enables you to greatly magnify the return (or loss) on money invested.
Buying a Call option on a stock gives you the right, but not the obligation, to purchase that security at a given price. Options are bought in round lots, or 100 share blocks. So buying one call of XYZ at $10 is the same as controlling $1000 worth of XYZ stock.
Calls can best be explained with an example. Let’s say in September you buy a Call for $300 on XYZ company, which currently trades at $30, that expires in December with a strike price of $40.
If you were to instead buy the stock outright, you would have to come up with $3,000 upfront. Now if the stock rises to $50, you would profit $2,000 or 67 percent. However, even though you bought the Call at $40 instead of $30, you only paid $300. That means you profited $700 from just $300, an astounding 233 percent gain!
Your risk is lessened with options as well. Using the same example, let’s say the stock dropped to $20 instead. If you bought the stock at $30, you’ll oversee a $1,000, or 33 percent loss. Because you are not obligated to buy the stock at $40 with the Call option, you would only lose your initial investment of $300. A 100 percent loss, but a mere fraction of the total of what it would’ve otherwise been.
Uses for call options
If you already own a stock, you can use call options to boost leverage in the stock, or as a fail-safe device. If you bought XYZ at $20 and it’s now at $40, you’re probably thinking of selling and locking in those gains; unfortunately, you believe the stock is going to continue to go up. No problem. Sell your stock and buy a call option at $40. You’ve locked in your gains, minus the cost of purchasing the call, and you can still take advantage of any upside movement.
Using options as a tool for leverage is probably the least risky way to spice up your portfolio. Unlike borrowing money, calls will only cost you the amount you paid for them – never more than that. It allows you to control more stock with less money and doesn’t lock you into action. Remember that they are called options — you get to choose whether or not to exercise them.
What about you? Do you use options in your portfolio? Why or why not?