Buying call options

A call option provides the holder the right, but not the obligation, to buy a certain security at a specified price on a specified date. 'Call' means to redeem or effect a claim. If an investor expects the 'company A' share to rise from the present price of 320, he can buy a call option on 'company A', e.g. with a strike price of 320. This call option gives the investor the right, but not the obligation, to buy 100 'company A' shares at a price of 320 at any time up to the expiry date. Options on single shares are normally of 100 underlying shares.

With an option premium of 20 per underlying share and a price of 360 upon the expiry of the call option, the investor's capital gain may be calculated as follows:
 

If the expiry price is 310 instead, the gain upon expiration is 0, meaning that the investor has suffered a loss of 2,000 – or in other words, the option premium or the price of the option.

The figure shows the potential capital gain and loss upon expiry of the call option. Note that the loss is limited to the premium, which has already been paid, whereas the capital gain is unlimited. The figure also shows the payoff for a call option when the option is 'in-', 'at-' or 'out-of-the-money'. A call option is said to be at-the-money when the strike price equals the price of the underlying asset. If the price is less than or above the strike price, the call option is out-of the money and in the money, respectively. The figure also shows that the investor will break even (BE) at a price level of 340.
 

Investment in options can achieve considerable capital gains. Let us presume once more that the price of the share increases from 320 to 360. If you invest in the share, your investment will yield a percentage gain of:

(360-320) / 320 = 12.5 %

Now compare this with a corresponding investment in the above call option with a strike price of 320 and has a premium of 20. Here the yield amounts to:

(40-20) / 20 = 100 %