How to put a “down payment” on your favorite stock

Editor’s note: Markets are closed for President’s Day, giving us a break from its confusing volatility. During the break, we’d like to share a strategy that many of you aren’t using — but should — to take advantage of the inevitable rebound in big stocks…while limiting your downside risk.

It’s a troubling market, and I know many of you are confused about what to do with your investments…

Pull the plug and hide your money under a mattress?

Hold on tight and pray for a rebound?

Or start buying with both fists?

First, if you want to build wealth, you have to think long term. Stay in the market…but consider moving money into sectors that beat inflation and generate dividends.

As for the other picks, there’s an ingenious way to bet that a particular stock or sector will eventually go up…while limiting your downside exposure to the market. In other words, this investment keeps your potential loss fixed… while providing unlimited benefit.

It’s called a call option.

Options trading gets a bad press. Many investors think it’s too risky… But as you’ll see, that’s not true. Options simply give options to an investor!

If you’ve never bought (or sold) an option before, a call option contract is the easiest to understand and a great place to start.

Today we’ll cover the basics of calling, as well as an example that illustrates how much money you can make with this strategy…in a short amount of time.

How a Call Option Works

Before coming to the formal definition of a call option, it is easier to think of it as a down payment. If you want the right to buy something in the future (like a property), you usually have to pledge a sum of money for that right. Buying a call option works the same way.

A call option contract gives the holder (buyer) the right to buy shares of a security at a specific price for a set period of time. Short-term options can be one month or less. Longer-term options can expire up to a year or more.

This makes options very versatile for an investor. They are actually one of the most powerful tools in my trading arsenal.

Keep in mind that buying a call option is a bullish trade. This means that you believe a stock will eventually go up. (Buying a put is the opposite – a bearish trade. More on that in another essay…)

For stock options, one contract represents 100 shares. So if you don’t want to buy 100 shares today, you can still expose yourself through a call option.

Let’s say a share of Acme co. is trading for $100. If you want to buy 100 shares, you will need to spend $10,000. But buying a call option can give you the same exposure at a fraction of the cost. Buying a call option contract on Acme might mean spending $500…but that’s only 5% of the $10,000 outlay.

And there’s another reason why investors like to buy call options: they have defined risks. All you pay for a call option (called the “premium”) is the maximum amount you risk on the trade.

Imagine that your risks are defined! This means you can sleep well at night knowing exactly what your downside is.

Here is an example…

A call option on AAPL

Let’s say you’re bullish on Apple, Inc. (AAPL), but you’re worried about the market in general. You think Apple is likely to rise over the next three months, but you want to limit your risk by buying a call option instead of buying stock directly.

Suppose Apple is trading at $100 and today is January 2. You decide to buy an AAPL April 17, 105 call option contract for $4.

This means that you are betting that AAPL will trade at at least $105 (the “strike” price) by April 17. Obviously, you will need AAPL to trade at $105 or higher before you see significant gains.

Now, since each option contract represents 100 shares, the $4 premium will cost a total of $400 (100 X $4). This is the premium paid AND the maximum you can lose.

Normally, if you want to buy 100 shares of AAPL at $100, you would pay $10,000. But, in this example, you are only responsible for 4% of that ($400). This is a tiny sum, all things being equal.

But, let’s look at the trade-off for this limited down payment.

At expiration, if the AAPL is below $105, you lose your $400. That’s the catch with options – you can lose 100% of the premium spent.

Now let’s see the upside potential…

If AAPL has good news and settles at $120 at expiration, the call option will be worth $15 ($120 – $105). Now we need to subtract the $4 premium we spent. So that leaves us with $11 or $1,100 on the trade. Not bad at all!

Turning $400 into $1,100 is an attractive return of 175% in about three and a half months.

Obviously, this is a very basic illustration, but it shows you how lucrative buying call options can be.

If you want to better understand how options work, read my free article Essential Options Trading Guide and my two course options at Investopedia Academy.

Luke Downey is editor-in-chief of Curzio’s The Big Money Report, which recommends the best stocks for long-term growth. Luke honed his strategy over many years at the institutional derivatives desks on Wall Street and as co-founder of investment research firm Mapsignals. Luke is also an options instructor with Investopedia Academy.

Editor’s note: When you’re ready to start enriching your portfolio with options trading, let Genia Turanova do the work for you. His advice in options trading, Money flow traderConsistently generates triple-digit gains from the market’s ups…and downs.

During extreme volatility – as we see now –this service is one of the most powerful ways to enjoy.

About Matthew R. Dailey

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