By Gary, on October 15th, 2012
Now you see the money-making benefit of buying a Call Option.
Are there any risks? What could go wrong?
Stating my beliefs up front, I do not believe in dwelling on the negative. I am very much in favor of having positive thoughts and words. Having stated that, one must acknowledge risk and be aware of how to manage it. So – are there risks to buying a call option? Absolutely.
What could go wrong?
Using the previous blog’s scenario:
Instead of the normal scenario, what if your broker called and recommended you purchase a Call Option. You both think the stock value for ABC will rise, so it’s just a matter of deciding the strike price and the time frame. After some discussion, it is decided to buy the option with a strike price1 of $50. Let’s say that the call option costs $2/share and the option covers 100 shares. Your out-of-pocket is $200. The time frame is set for four months.
However, instead of the stock going up, it doesn’t move up at all for three months, very contrary to what you and your broker thought would happen. You get nervous at this point in time since no one else wants to buy your call option and you only have a month left on your contract. You hang in there and watch the stock rise to $49.50 when the contract is up. You now have to buy 100 shares of ABC Stock at $50/share. It breaks down this way:
Valuation $49.50 – $50 = $-0.50
Less Purchase = $-2.00
Your Value after Sale = $-2.50
So – at $-2.50 per share you have a $250 loss in four months. And you now have to purchase the 100 shares of stock at $50 per share equaling $5,000.00. You have effectively purchased 100 shares of ABC stock for a total price of $5,250.00. Your ABC stock is currently worth $4,950.00. If you sold it today, you would net a $300.00 loss in four months. This is a 6% loss while the stock price has increased 10% in the same four months.
This is not a huge loss.
However, the problem is that you had to spend $5,250 rather than make a profit of $350. Therefore, your risk is spending more than you wanted to and having a stock in a company that is not performing as well as you anticipated.