In very basic terms, when you purchase a call option, you profit if the underlying stock goes up and you MAY lose money if the underlying stock moves lower. Because you don’t own the actual underlying asset, buying calls is substantially cheaper than buying stocks or any other underlying asset that you may be interested in trading.
When you buy a call, you gain the right to buy the underlying asset at a specified price on or before the expiration date. You are never required to purchase the underlying asset, but if you decide to do so, you have that right.
To gain the right to purchase the underlying asset, you have to pay a premium to the seller of that option. In return for the payment, you gain the right to control the underlying stock.
Because we are speculating on the rise of the underlying asset, we simply want to earn a profit when the underlying asset rises. We do not want to own the underlying stock and will offset or sell the call option if it happens to rise as a result of a rise in the price of the underlying asset.
The Upside To Buying Call Options
One of the most desirable aspects of buying call options is the low cost. For example, a stock may cost $100 per share, while the underlying stock costs $5.00 per share. This allows you to participate in the price movement of the underlying asset for a limited time, without having to purchase it outright. This can be extremely advantageous if you cannot afford to buy the underlying asset because the cost is just too high. The call option is only a fraction of the cost of the underlying stock and can offer you a chance to participate in the potential price gain that would otherwise be prohibitively expensive, if you had to buy the actual asset instead.
Another very important reason why speculators would opt for a call option instead of the underlying asset is leverage. For a very small percentage of the actual cost of the underlying stock, you are able to control a substantially larger number of shares instead.
For example, if a call option costs $5.00 and the underlying stock costs $100.00 per share, you would have to spend $10,000 to control 100 shares of the underlying stock. If you purchased the call options instead, you would spend $500.00, and that would give you the right for a limited time to control 100 shares of the underlying stock.
Therefore, if you have a small account and you believe that an expensive stock is going to move higher, buying the call option instead of the underlying stock may be the only viable alternative.
Another reason for purchasing a call option instead of buying the underlying asset is less risk. First of all, when you buy a call option, you know ahead of time how much you can potentially lose on the trade, so your risk is limited ahead of time, which is a major advantage. While you can lose the entire cost of the option that you purchased, there is no further liability that comes with owning a call option; but if you purchase the stock instead, you can potentially lose more than you originally intended or planned on that specific trade.
To give you a very simple and somewhat common example, if you purchase 100 shares of stock priced at $100 dollars per share and a negative earnings report or a major downgrade is released several hours after the stock market closes for the day; the stock can potentially open the next day much lower than what you originally paid for the shares. If the stock opens at $65 dollars per share for example, the $10,000 that you paid for the 100 shares would now be worth only $6,500; in other words you would have lost $4500 on the trade, without having the ability to mitigate the loss because when the report or downgrade was released the market was closed and you had no opportunity to liquidate the stock shares at a higher price.
If instead you purchased 1 call contract (equals 100 shares of stock), your exposure and maximum risk would be limited to $500.00, even if the price of the stock moves from $100.00 per share to $65.00 per share or even lower.
In conclusion, buying call options can often times make more sense and can make a great alternative to buying the underlying asset, especially when you anticipate a quick price move to the upside in a very short period of time. While other times it may make more sense to purchase the underlying asset.
Always consider the upside and the downside to each trade.