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What Is the Effect on a Call Option's Price That Results From an Increase in the Stock Price?

Original post by Leslie McClintock of Demand Media

When you buy an option, you are buying a choice. As the owner of an option, you have the right to buy or sell a given security at a given price at a specific time. There are two kinds of options: The option to buy, and the option to sell. The option to buy is called a "call" option, and the option to sell is called a "put" option.

Call Options and the Strike Price

When you purchase an option to buy or sell a security, you do so at a specific price. For example, you may purchase an option guaranteeing you the right to purchase 100 shares of the Acme company on May 1 at $10 per share. That $10 figure is called the "strike" price. You own a call option on Acme with a strike price of $10 per share.

"In the Money" Options

When the price of a share of Acme stock rises above $10, the value of the call option rises. This is because the higher the price of Acme stock, and the closer the May 1 option date, the more certain an eventual payout becomes. When the stock price is higher than the strike price, the option is said to be "in the money." When a stock price rises, the price of a call option tends to rise with it.

Put Options

A "put" option is the right to sell a security at a given price. For example, if you have shares in the Acme company and you don't want to unload them because you would have a capital-gains tax problem -- or perhaps you have an agreement with the company not to sell restricted shares of stock -- you may be able to "lock in" the current price by buying a put option. The put option would guarantee you the right to sell your shares at something close to their current price.

Uses of Options

Some investors use options contracts to generate extra income from a portfolio. If you own shares in the Acme company, you can sell call options and collect money from those purchasing the options. Occasionally, you will have to sell the stock for less than its current value. But in the long run, you may have many weeks or months of additional income. Alternatively, some investors use options to protect themselves against sudden changes in the price of a commodity or stock. For example, an airline may purchase an option to buy jet fuel at today's price on a certain date in the future -- paying a small premium to protect itself from a potentially crippling move in the price of jet fuel. Some speculators use options as a form of leverage: They can reap the benefits of a large move in asset prices with the purchase of options contracts with relatively small amounts of capital. However, if the market moves against them, they could lose their entire investment.

                   

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About the Author

Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.

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