Now that we have an understanding of the different choices you have when trading options, let's talk specifically about the pros and cons of a buying a call.

As a call buyer you are making a bullish assumption on a stock, plain and simple. Remember that you are purchasing the right to buy a stock at the strike price you choose, but you are not obligated to do so.

Let's say you notice that XYZ was trading at 25, but has recently dropped to 20. It is your belief that this drop is only temporary, and you feel it will return to 25 within a few weeks. The normal course of action is to buy the stock and wait for your assumption to be correct. For every 100 shares you purchase you will have to use $2000 of buying power. If XYZ continues to decline you continue to lose on your stock purchase.

Since you read our last 2 articles you have a general understanding of options, so you decide to buy the $20 call for $0.50. What does this mean? This means that you will spend $50 (1 contract = 100 shares) to make the same directional bet as buying stock. If XYZ continues lower you can only lose the $50 you initially paid, and never have to buy the stock. (the last part is important to remember, and we will further address this as we go) But what if XYZ goes up? As a stock buyer your profit is technically unlimited (theoretically a stock can only drop to $0 but could go up forever). As a call buyer your profit is also unlimited (remember a buyer of a call will see a rise in the call value as the underlying goes up).

The pro's to call buying - So, by now you should be seeing the benefit that the call buyer has over the stock buyer. The first benefit is the capital requirement to place the trade. The second benefit is that the risk is only limited to what you pay for the call ($50 in our example). So why wouldn't everyone just buy calls when they think an asset will bounce?

The con's to call buying - In our example you paid $0.50 for the $20 call option while the stock was trading at $20. As long as the stock bounces as you predicted then you should see a profit. If XYZ goes sideways, drops, or only has a very small bounce then you will notice a decline in the price of your option. Remember that your option has an expiration date and the closer you get to that expiration date the less your option is worth (there are actually many factors that determine an options theoretical value. We will cover them in later articles). So a call buyer needs to be accurate with his directional assumption but also needs his assumption to happen quickly.