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RATIONALE OF BUYING CALL OPTIONS

RATIONALE OF BUYING CALL OPTIONS

Discuss RATIONALE OF BUYING CALL OPTIONS within the Financial Management ( FM ) forums, part of the Resolve Your Query - Get Help and discuss Projects category; There are broadly three reasons why an investor could buy a call option instead of buying the stock outright. These ...

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RATIONALE OF BUYING CALL OPTIONS
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Sunanda K. Chavan
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sunandaC
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RATIONALE OF BUYING CALL OPTIONS - October 8th, 2010

There are broadly three reasons why an investor could buy a call option instead of buying the stock outright. These are as follows:

1. Return on Investment

An investor anticipates that a stock is shortly going to appreciate from Rs. 300 to Rs. 400 per share and buying 100 shares of the stock would involve an investment of Rs. 30,000. However, a call option on the stock is available at a premium of Rs. 20. Let us assume that the stock's share actually goes up to Rs. 400 within the currency of the option. The investor thus makes a profit of Rs. 80 per share (400 (300+20)].

His investment was only to the extent of premium paid, i.e. Rs. 20 per share. Thus, the investor got an appreciation of 400% on his investment. Had he bought the stock outright, the investor would have made Rs. 100 per share on an investment of Rs. 300, i.e. 33%. This should be sufficient motivation for the investor to go in f6r call options on the stock as against outright buying of the stock.

2. Hedging
Trading with the objective of reducing or controlling risk is called HEDGING. An investor, having short sold a stock, can protect himself by buying a call option.

In the event of an increase in the stock's price, he would at least have the commitment of the option writer to deliver the stock at the exercise price, whenever he is to effect delivery for the stock, sold short. The maximum loss the investor may be exposed to would be limited to the premium paid on the call option. Options can thus be used as a handy tool for hedging.

3. Arbitrage

Arbitrage involves buying at a lower price and selling- at a higher price, if it so exists. As in any other trade, options arbitrage provides an opportunity to earn money by exploiting the pricing inefficiencies, which may exist within a market or between two markets or two products and as a result tends to bring perfection to the market.
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