Many investors believe that options trading is the riskiest way to bet on the stock market, and it's true that many traders use options to make aggressive calls on which direction a particular stock will go. But call options aren't just a vehicle you can use to make high-risk gambles in your investing. Many strategies using call options can help you reduce risk in your portfolio if you use them correctly. Let's take a closer look at what a call option is and when you might want to consider using call options in your portfolio.
What a call option is
Call options give their owner the right to buy stock at a certain fixed price within a specified time frame. A typical call option allows you to purchase 100 shares of stock from the investor who sells you the call option, and you have to make a decision about what to do before the option expires. If the price of the stock on the open market rises above the specified price in the call option, which is also known as the strike price, then it will generally make sense to exercise the option and buy the stock at the lower strike price. Conversely, if the market price of the stock is still below the strike price of the call option, then it won't make sense for you to exercise the option, and you'll simply let the option expire without doing anything.
The beauty of the call option is that while it offers the same upside potential as owning stock does, it has a more limited downside risk. With a stock, investors can see the value of their shares go all the way to zero, resulting in massive monetary losses in most cases. It's true that a call option can also lose all its value, and given the way it's structured, total losses happen a lot more often than with stocks. Yet because you choose the strike price of the option you buy, you have more control over how much money you risk -- and usually, the cost of a call option will be far less than you'd pay for shares of stock.
How call options can make -- and save -- you money
Let's look at an example. Say a stock trades at $97 per share, and you think it's likely to go up in the near future. You could buy 100 shares of stock, paying $9,700. You could also buy a call option that would give you the right to pay $100 per share for stock any time in the next two months. Based on current market prices, that option would cost $1.75 per share, or a total of $175.
If you're right and the stock goes up to $120 per share by the time the option expires, then the two strategies produce fairly similar profits on an absolute basis. If you had bought the stock outright, it would be worth $12,000, producing a profit of $2,300. If you had bought the option, it would be worth $2,000 -- the $120 current price less than $100 strike price, times 100 shares -- and your profit would be $2,000 minus the $175 you paid for the option or $1,825.
The weakness of the call option is that if the stock only goes up a little, the option's value can go down. For instance, if the stock goes up to $100 per share, buying the stock outright results in a $300 profit, but the option would lose all of its $175 value.
Yet the true value of the call option comes if you're completely wrong in your bullish call on the stock. If the share price falls to $80 per share, then buying the stock outright would cost you $1,700 in losses. But with the call option, you can never lose more than the $175 you paid upfront -- potentially saving you from a massive hit to your portfolio in an unexpected decline.
Call options do involve risk, but used correctly, they can actually help you make smart investment choices without putting as much of your hard-earned capital in danger. For many, that makes call options a useful tool in putting together a profitable long-term investment portfolio.
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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.