Buying a call option is a popular strategy used by investors to profit from an expected rise in the price of a specific asset. In this article, we will explore the mechanics of buying a call option using the example of the PowerShares DB US Dollar Index Bullish ETF (symbol UP).
What is a Call Option?
A call option is a type of financial contract that gives the buyer the right, but not the obligation, to purchase a specific asset (the underlying asset) at a predetermined price (the strike price) on or before a specified expiration date. The buyer pays a premium to the seller (also known as the writer) of the call option for this privilege.
Example Scenario: Buying a Call Option on UP
Let’s assume that UP is currently trading at $20 per share, and you believe that the price of UP will rise in the coming months. To capitalize on this bullish outlook, you decide to buy a call option on UP.
You find a call option with a strike price of $22 and an expiration date in December 2021. You pay a premium of $75 for this call option, which allows you to buy 100 shares of UP at $22 per share anytime before the expiration date.
Profit Potential of the Call Option
Now, here comes the exciting part. As UP’s price rises, the value of your call option increases. Suppose UP’s price reaches $25 per share in September 2021, three months before the option’s expiration date.
At this point, your call option gives you the right to buy 100 shares of UP at $22 per share, which is still below the current market price of $25 per share. The option’s value has surged, and you can sell the call option for a profit.
Understanding the Features of a Call Option
To fully grasp how buying a call option works, it’s essential to understand its key features:
- Contract: A call option is a contract between the buyer and the seller.
- Underlying Asset: The call option is based on the underlying asset (in this case, UP shares).
- Strike Price: The agreed-upon price at which the underlying asset can be bought if the option is exercised.
- Premium: The amount paid by the buyer to the seller for the call option.
- Expiration Date: The date when the option contract expires, and the buyer’s right to exercise the option ends.
Differentiating the “Moneyness” of Call Options
The “moneyness” of a call option refers to its relationship to the current market price of the underlying asset. There are three scenarios:
- Out of the Money (OTM): When the strike price is higher than the current market price of the underlying asset.
- At the Money (ATM): When the strike price is equal to the current market price of the underlying asset.
- In the Money (ITM): When the strike price is lower than the current market price of the underlying asset.
Using Call Options for Safety or Hedging
In addition to speculative strategies, call options can also be used for safety or hedging purposes. For example, investors holding a long position in an asset might buy call options as a form of insurance against potential price declines.
Buying a call option is an effective strategy for investors who want to profit from expected price increases in an underlying asset. Understanding the features and moneyness of call options is essential for successful trading. Additionally, call options can serve as valuable tools for hedging and risk management in an investment portfolio.
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