Options are investments whose ultimate value is determined from the value of the underlying investment. Therefore, options are derivatives, which commonly have stocks as the underlying security. This is not always the case, as indexes, commodities, and other securities are sometimes used as the underlying investment too. At its simplest, a stock option is really just a contract that gives a person the right (but not necessarily the obligation) to buy or sell 100 shares of stock at a fixed price by a set expiration date.
A “call option” gives the holder the right to buy 100 shares (the standard number of shares per option contract) of the underlying stock at the strike price (a fixed amount) by the expiration date of the option – for a premium. The premium amount is determined by market forces, and represents the maximum amount that an investor can lose (plus commissions). So for an option with a premium of $3, the investor would pay the premium per share multiplied by the total number of shares in the option (100), or $300, plus commission fees. Should the investor decide to exercise the option, he/she would still need to pay the strike price on the underlying stock, plus any commissions.
Investors are encouraged to consider using the “buy call” option investment strategy when they perceive that they are in a “bull market.” If the market is considered “bullish”, it means there has been a sustained period where investment returns have been rising faster than historical averages. Bull markets arise for a number of reasons, but are most commonly observed during economic recoveries or booms. The most notable bull market in recent memory began in the early 1990’s, and was fueled by economic recovery, and a boom in the high-tech sector.
The “buy call” option investment strategy is perfect for a bull market as it gives the investor the advantage of locking-in a purchase price for a stock that may rise well above the strike amount, while limiting potential loss to the premium paid for the option (plus commissions). Higher strike prices are usually intimidating for investors but, are less of a concern in a bull market.
The break-even point for the “buy call” option strategy comes when stock price rises above the strike amount plus the premium, plus any commission fees paid. Every point above this amount represents an additional point of profit. Of course, the option must be exercised by the holder in order for any potential profits to be realized. Basically, the “buy call” option strategy has the potential for unlimited gain, carries limited risk, and is therefore considered a great investment during a bull market. However, keep in mind that all options suffer from time decay, in which the value of the option decreases as the expiration date approaches, since there is lesser time to realize a profit, and continue to lose value as the expiration date of the option approaches.