If you think a stock price is going to go up, then there are 3 trades that you can make to profit from a rising stock price:
- you can buy the stock
- you can buy call options on the stock, or
- you can write put options on the stock
Buying stock need huge capital investment plus your total capital is @ risk
Writing put option also need huge margin and risk associated with it is unlimited
Buying call option give u unlimited profit upside and limited risk downside.
Only enemy of call option is time so u should book your profits as early as possible.
Let’s understand using an example. Suppose, today’s date is 18-APR-2012 and you buy a RELIANCE CALL option (strike=800, EXPIRY MAY 31) @ Rs. 20 per contract when RELIANCE stock was getting traded at 760. Let’s see what happens after options expiration.
Case I : Reliance stock price greater than the strike price. Reliance stock trading at 840on expiry day cut-off time
Net profit = (current price – strike price) - premium = (840–800 ) -20= Rs. 20 per contract
Case II : Reliance stock price less than strike price (800) on expiry day cut-off time
Net loss = Premium paid = Rs. 20 per contract
So when you buy a CALL option you have unlimited profit potential but limited risk or downside.