Participate in Upward Stock Price Movement With Limited Downside Risk
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
ZYX is trading at $44.25, so 100 shares of stock would cost a total of $4,425. However, an investor could instead purchase one six-month ZYX 45 call, which represents the right to purchase 100 underlying ZYX shares at $45 per share, for a quoted price of $3.25. The total cost for the call would be: $3.25 x 100 contract multiplier = $325, a fraction of the total stock purchase price. Instead of committing $4,425 on the purchase of 100 ZYX shares, spending only $325 for the purchase of one call would leave a balance of $4,100 that could then be invested in short-term, interest-bearing instruments.
By purchasing the call the investor is saying that by expiration he anticipates ZYX to have risen above the break-even point: $45 strike price (at which price ZYX can be purchased no matter how high it has risen) + $3.25 (the option premium paid), or a ZYX share price of $48.25. The investor's profit potential is unlimited as ZYX stock price continues to rise above $48.25. The risk for the call purchase is limited entirely to the total premium paid for the contract, or $325, no matter how low ZYX stock price declines.
Before expiration, if the call purchase becomes profitable the investor is free to sell the option in the marketplace to realize this gain. On the other hand, if the investor's bullish outlook proves incorrect and ZYX declines in price, the call might be sold to realize a loss less than the maximum.
Consider three possible scenarios at expiration:
- ZYX closes above the break-even point
- ZYX closes between the strike price and the break-even point
- ZYX closes below the strike price