Call option and put option are arguably the most common terms you will come across when trading binary options. To really understand the underlying dynamics of binary options trading, you obviously have to understand the very basics of how to buy and sell call and put options. Here, we’ll delve into call options — what are they and how do you buy them?
What Is a Call Option and How Do You Buy One?
A call option is principally a contract that allows a buyer to purchase a specific amount of an asset at a particular price within a given frame of time. The strike price is the cost of the amount of assets bought, while the frame of time is known as an expiration time.
"A call option gives the holder the right, but not the obligation, to purchase 100 shares of a particular underlying stock at a specified strike price on the option's expiration date"
At the same time, the seller of a call option is obligated to sell the asset at a specific strike price. The buyer pays the seller a premium because of the risk the seller has accepted to undertake by selling the underlying security.
How do you buy call options?
New traders usually start trading binary options by buying call options; it’s simply the easiest way to get started in the options trade. There is also potential to generate significantly large profits.
So, let’s say company ABC sells its stocks at $20 each. The strike price for the call option contract is set at $3 with an expiration period of 1 week. You spend $300 to buy 150 shares.
As you buy call options, your basic assumption is that the price of the asset will rally. Let’s say that in this case, your assumption was correct and the prices rallied from $20 to $30. At the end of the expiration date, you would have made a profit of $600.
There are different strategies for profitably buying call options. The example above is a long call strategy, a basic technique that any novice trader can apply.
Microsoft stock is currently trading at $100 per share. Now you purchase one call option contract on Microsoft with a $100 strike and at a price of $2.00 per contract. You are interested in 100 shares, so the actual cost of this option will be $200 (100 shares x $2.00 = $200).
Let's see what will happen to the value of this call option under three different scenarios:
- The option expires and Microsoft is trading at $105.
In this scenario, you can use the option to purchase the shares at $100, then immediately sell them in the open market for $105. Technically speaking, you are in the money. Because of this, the option will sell for $5.00 on the expiration date and $5 x 100 shares = $500. Because you purchased this option for $200, the net profit from this trade is $300.
- The option expires and Microsoft is trading at $101.
The call option will now be worth $1. Since you spent $200 to purchase the option, you have a net loss on this trade of $100.00 in total). This option is called at the money because the trade is essentially a wash.
- The option expired and Microsoft is trading at or below $100.
If Microsoft ends up at or below $100, then you are out of the money and you will lose 100% of your money (in this case, the full $200). A lot of binary options brokers promoted on this site provide a return to loss feature - rebates or sell back facilities offered for out-of-the-money options contracts.