Know your options: Buying a call

Buying a call is one of the simplest options strategies. So how does it work, and why might a trader employ it?

First, it is important to understand that there are two kinds of options: calls and puts. A call grants its owner the right to buy a stock for a given price within a given time frame. Conversely, a put gives its owner the right to sell a stock for a given price within a time frame.

If a trader buys a call on a stock, he or she generally needs the stock to rise in order to make money. Specifically, the trader needs the stock to rise above the call's strike price by more than the price of that call option.

While buying a call and buying a stock are bullish strategies, there are some key differences. First, a call costs a certain amount of money, which is called the options premium. This premium is generally a fraction of the actual stock price, making calls more cost-effective, and offering the opportunity to make far greater percentage gains if the stock does rise.

Also, since one is only paying for the option instead of for the stock, one's risk is limited to the options premium. This makes buying a call ideal for situations in which one believes a stock could rise substantially, but also presents serious downside risk.

Another key difference between buying a stock and buying a call option is that options expire. That means that the stock has to make the requisite move by the call's expiration date, or else the option will expire worthless.

How does this all come together? Well, let's say a trader is buying the March 100-strike call on XYZ stock for $5 per share. In that case, the trader needs shares of XYZ to rise above $100 by more than the $5 being spent, or above $105, by March expiration. If the stock moves to $200 within that time frame, the trader will see profit of $95. Conversely, if the stock drops to $0, the trader will only lose the $5.

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