Practical Example: Buying a Call Option

Let’s say that you are of the opinion that Microsoft is poised to perform well in the future because of its recent release of Windows 7 and its Xbox 360 gaming system.  Through technical and/or fundamental analysis you form a BULLISH opinion on MSFT and given your options trading knowledge, you decide to buy a call option.

Trade Details: With MSFT @ $30, you buy a 32.50 call option expiring in Jan 10 for a debit of $1.00.  Your trading platform should automatically deduct $100 from your account.

Trade Breakeven = $32.50 + $1.00 = $33.50 (MSFT stock must reach $33.50 to make a profit)

Maximum Risk = $1.00 (trading account will be debited $100) – Be sure to look at the Risk Profile (risk graph)

How to Make Money:  By the 3^rd Friday in Jan 10, MSFT must close above the breakeven point of $33.50 for the position to make a profit, otherwise you will lose the debit paid to enter the trade.  The maximum you can lose is the premium paid or $1.00.  This will actually be $100 because the premium gets multiplied by 100.

Managing the Trade:  If your initial opinion about MSFT changes and you no longer are confident that MSFT will trade above $33.50 by Jan 10, you have two choices – either close out the position by selling the call option or turn it into a spread, etc.  For beginners, I suggest to just close out the position for a credit.

Things TO Consider:

As a trader, you have always have to consider RISK and reward.  I intentionally  listed risk before reward because your mindset as a trader should be “How much can I lose” before you even think about reward.  Most traders do not ask the risk question, but only focus on reward.  Do not make that same mistake!!

I want you to be able to manage your risk first, so if a trade does NOT go your way, then you will be prepared for whats to come and will survive to trade another day!!  This is not just applicable to options, the same is true for a trader who deals in stocks, forex or futures.