The Advantages of Buying a Call Option Instead of a Stock

Many people are dissuaded from investing in the stock market because they either feel it is too risky or because they don't have enough money to begin trading. While there is no surefire way to eliminate risk there is a way to take a position in a stock without directly purchasing the stock. This is done through purchasing call options. One call option gives the owner (or buyer) leverage over 100 shares of stock. This is advantageous for many investors because the call option can be purchased for much less than the stock with no loss in profit potential.

Now there are times when owning a stock may be a superior strategy, but for many investors it would behoove them to learn about options since purchasing call options is cheaper and, in some cases, less risky. Let's see how it works.

If you purchase a call option then you have the right to buy 100 shares of that stock anytime before the option expires. However, you don't have to exercise your option to make a profit. If the stock increases then your option will increase in value and instead of exercising your option and taking a position in the stock, you can simply offset your option for a profit. This can be done at any point prior to expiration.

Perhaps a few examples will help clarify this strategy. Say stock XYZ is trading at $35.00 a share, and you expect the stock to rise over the next few months. If you buy 100 shares of XYZ then your total cost will be $3500.00. If the stock goes to $40.00 over the next four months then you can sell the stock for a $500.00 gain. This is a good return, but what if you had purchased a call option instead?

Instead of buying the stock, say you bought a $35.00 call option with an expiration of six months. This would also give you leverage over 100 shares of stock but the cost would be much less. While option prices vary, the cost would probably be somewhere between $500 and $600. This would give you the same position for about 1/10th the cost of purchasing the stock. Say, over the next four months the stock price goes to $40.00, then you can offset your option for, say, $900-$1100 (it depends on the stock's volatility) and claim a profit. Buying the option gives you a better return, and approximately the same dollar amount, as buying the stock.

Options have a few quirks, however, that stocks do not. Options do have an expiration, so the stock will need to be over the strike price sometime before expiration to realize a profit. If the stock price falls and does not recover then your option will expire worthless. The most you can lose is the price you paid for the option. The owner of a stock can always wait in the hopes that the stock will recover. There is no time concern. That is why one should tailor the option to the anticipated performance of the stock. Some options (known as LEAPS) don't expire for a year or more. While these will cost more than options that expire sooner, they're still much cheaper than buying the stock.

The buy and hold investor, the guy who rarely sells, might be better just buying stocks. However, for traders -- those seeking short-term price profits -- options might make a better strategy.