A call is an option which gives the owner the right, but not the obligation, to buy an asset at a predetermined price within a given time period.
An investor would buy a call option on an asset when they believe it is going to increase in price but do not wish to buy the asset itself.
An example of how a call option works is as follows:
- On October 1st, the stock price of Morgan Stanley is $15
- The cost of a December call with a strike price of $20 is $2
- The total price of the contract is $2 x 100 = $200
- The breakeven point is $22 per share ($20 + $2)
- On November 1st, the stock price of Morgan Stanley is $18
- This is less than the strike price so the option is worthless and the loss is $200
- On December 1st, the stock price of Morgan Stanley is $27
- The profit on the call option is ((27-20-2) x 100) = $500
- The maximum loss on the option is always $200 (the lowest it can be valued is 0) but the maximum profit is essentially limitless, and the starting investment is very small
Options require relatively low levels of investment compared to the return and have low maximum loss amounts, therefore they are good for speculation purposes.
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