The easiest place to begin to understand how options work and why the may be a good investment tool is to go right for the easiest to understand, the long call. I remember that my first bit of insight into trading options was through a great friend, Marc Friedfertig, author of “The Electronic Day Trader”. We were on the “D” train heading south into Brooklyn when my instruction began, and as with many, the long call was my beggining.
We already know that buying a call gives the investor the right to purchase 100 shares of the underlying stock at a specific price up until the expiration date of that call option. But who should buy this option? This is a good position for those just getting their feet wet in option trading as it requires minimal skill and is easy to understand. An investor who believes that the underlying stock will increase in value, yet wants to invest limited capital and has no problem in absorbing the risk of the premium paid, yet still have a potentially unlimited maximum reward should consider buying a call.
Buying a call is about as basic as you can get in options trading, which is why it is a perfect entry level trade into these types of investments. Later we will go over how this and other types of options can be combined to create other strategic investments to serve a multitude of purposes, but for the beginner buying a call is usually a great starting point.
So, we have now purchased a call, referred to as long call, if you were the seller of the call, you would now be short the call, remember for every buyer there must be someone who has the contra point of view just as in buying and selling stocks. Your maximum risk is the premium you paid for the call, the maximum reward is unlimited and the breakeven point, (the price at which you would neither make nor lose money) would be the strike price minus the premium you paid for the call. Strike Price! Wait, you never mentioned a strike price! What the heck is that? Remember earlier we mentioned a specific price you can purchase the stock for up until the Call’s expiration date? That price is known as the strike price.
In later articles we will not only go over other types of option contracts but how time decay and price fluctuations can also affect the price of the option. But for now, go to the Wall Street Journal or Investor’s Business Daily and notice how option prices and expiration dates are listed as this could be the subject of our next post on the basics of Option trading.