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CALL OPTION

investing wednesday word of the week Jan 22, 2020

Definition
A call is a type of options contract that gives the owner the right to buy a stock at a certain fixed price within a specified timeframe.

Why It's Important
As I discussed in last week's word, Options, they are a good way to hedge against a downturn in the market if used correctly.  Let's take an example:

Let's say a stock trades at $100 per share, and I think it's going to go up pretty soon. I  could potentially buy 100 shares of stock, paying $10,000 OR I could buy a call option that would give you the right to pay $110 per share for stock any time in the next two months.  My buy-in for the option is typically $1-$2 per share.  So, I would pay $200 for that right at the high end.  This is a sunk cost (I'm not getting it back regardless of what happens).

If I'm right and the stock goes up to $130 per share by the time the option expires, then I can exercise my option and purchase the stock at $110, therefore, making a profit of $20 per share even if I sold them right after purchase. 

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 $105 per share, I wouldn't exercise my option and take the loss of my $175 buy-in (sunk cost, remember).

On the flip side, this could work out great if I am completely wrong!  Let's say the same stock now trades at $90 per share.  Instead of taking a loss of $2,000 (110 - 90 x 100), I can just take my $175 loss and be on my way. 

There are pros and cons to trading options.  As always, do your research!

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