Call on Me?

A call option is the right (your right if you buy one) to buy a stock at a certain time for a certain price. It is a type of derivative.

This Sounds Complicated. When Exactly Would You Buy a Call Option?

OK, let’s take a scenario in which you would buy a call option instead of a stock.

In 2008 there were many stocks that fell in value significantly.  You wanted to buy them. But, at the same time, things still looked really scary. You were pretty sure the economy just had to get better, but you really didn’t want to lose all of your money on the off chance you were wrong (which is rare, since you’re always right).

In this situation—buy a call option.

But Why Would You Buy a Call Option Here?

Say the stock you wanted to buy is $20. If you bought 100 shares, that would cost $2,000.

When you buy a call option, you pay a fraction of the value of the stock. This cost will vary based on stock price and perception of risk in the market. Let’s say this cost is $1.

So you buy this call option for the right to buy the stock (within a year period) at $25. You pay a dollar per share, or $100.

OK. Am I Happy or Not?

It depends upon what happens with the stock. Let’s take two scenarios.

Scenario 1 – The company goes out of business
Call option – You lost $100
Stock – You lost $2,000

Scenario 2 – The company goes to $30 a share
Call option – You make $5 on 100 shares ($500) minus what you paid ($100). You made $400.
Stock – You make $10 on 100 shares. You made $1,000.

What’s the Bottom Line?

With a call option, you know where your loss is capped right off the bat.

It’s a way to manage risk in some cases. There is less potential profit, but less potential loss as well.

P.S. Put on an off-the-shoulder sweatshirt, a thong leotard, listen to Call On Me and read the article again. It will become clearer.