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How To Invest In Stock Options – The Mechanics Of Call Options

By Jason Markum

Investing in the stock market can be particularly tricky. One part of the stock market that many individual investors seem to have a great deal of trouble understanding is the options market. Many people find options trading to be incredibly complicated, but the fact of the matter is… it can be quite easy once you get to know it and understand its workings.

In this article I want to discuss some of the basics of stock options as far as the mechanics of call options go. That is I want to talk about what call options are and how you can profit from them.

There are basically two types of stock options. The first kind is called a “call” option. A call option gives you the right to buy a security at a set price sometime in the future. The second kind of option is called a “put” option. A put option gives you the right to sell a security at a set price sometime in the future.

I think most of your average investors understand that concept fairly easily, but when you get into more specifics things start to get a little confusing and that’s a shame because it’s not that much more complicated than what I just said above.

I think the best way to explain is to simply give you an example. Imagine a company’s stock sells for $30 a share. You want to buy a call option that expires in three months giving you the right to buy one share of stock in the company for $35. What this means is that anytime in the next three months you have the option to buy a share of stock for only $35 no matter how high the share price has risen too. It’s easy to understand how you would make money on such a strategy. If the share price rises to $50 a share within three months, then you have the right to buy it at only $35… at which time you could turn around and sell it on the major stock market and pocket the $15 difference as your profit.

The price of purchasing that option, which is known as a premium, may be just .50 cents. That .50 represents basically the time value of the option and it is usually based on the length of time before the option expires as well as sometimes the likelihood of the stock actually reaching that specific option price.

If most investors think that there is a very large chance that the stock will reach $35 a share, then the price of that option is going to be much higher.

The risk involved in purchasing this type of option is also easily understandable. If the price of the share doesn’t rise to $35 a share, then your option will expire and be completely worthless. So what is your risk? Well, it’s easy… you risk that $.50 or whatever it cost you to buy the option and you’ll lose that money if the share price doesn’t rise above $35 a share.

Now imagine that the shares have risen in price to $45 per share. Your call option is now worth $10. How did I figure that? It’s easy, you have the right to buy the share at $35 a share and you can sell that same share on the market for $45 a share. $45 minus $35 equals $10 which is what your option is now valued at. Think about it; that option that you bought for $.50 is now worth $10!

Pretty easy huh? Yes it is. Investing in call options doesn’t have to be any more difficult than that.

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