What Is the Maximum Loss That Could Occur for a Purchaser of a Call Option?
When an investor purchases a call option, he hopes that the market value of the asset is higher than the strike price of the asset in the option contract. The strike price is the agreed-upon amount the investor can purchase the asset for at the end of the contract. Similar to other investments, purchasing call options involves risks. However, the risk of money lost is limited. The maximum loss a purchaser of a call option can incur is the total amount necessary to buy the option. Investors must understand this concept to successfully invest in call options.
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Maximum Potential Loss
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If the buyer chooses not to exercise the option, the maximum amount a buyer can lose on a call option is the premium and commission fees paid for the option. The premium is the amount of money required to acquire the option. For example, suppose you buy an option of 100 shares for $400 -- a premium of $4 per share -- and the exercise price is $35 per share. If at the end of the expiration date the market price of the stock is $25 per share, you will not exercise your option to buy the stock because you can purchase it for less on the market. Therefore, the option expires and you lose your $400 investment.
Factors Affecting the Premium
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The premium of a call option is affected by several factors. Time is the primary factor affecting the premium. The more time left until the option expires, the higher the premium of the option. As the expiration date nears, the price of the premium declines. The volatility of the underlying asset also plays a role in the amount of the premium. According to information stated on the website eNote.com, an option with an underlying asset that fluctuates in price commands a higher premium than if the underlying asset expects little movement in price.
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Advantages of Buying Call Options
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One primary advantage of purchasing call options is that you can invest with a small amount of money. A call option gives an investor the right to buy the underlying asset but does not obligate the investor to buy the asset. Some investors attempt to make money simply by purchasing call options and selling the option for a profit later. Another advantage of investing in calls is that investors know upfront the amount of the underlying asset because it is written in the option contract. Knowing the price of the underlying stock allows investors to plan their strategy.
Disadvantages of Buying Call Options
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Options often trade at a low volume, which reduces the liquidity of the asset. In some cases, investors experience a difficult time trying to sell call options because of the low number of available buyers. Investors experience an even greater challenge trying to sell the option as the expiration date nears. Another disadvantage for some investors is that an option is a complicated financial instrument not suitable for novice investors. Each time you purchase or sell a call option, you must pay a commission fee. This can result in a disadvantage for the small investor.
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References
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