Can someone help me understand this. Per this article - http://www.theoptionsguide.com/long-call.aspx In the "Example" section it says - "Say you were proven right and the price of XYZ stock rallies to $50 on option expiration date. With underlying stock price at $50, if you were to exercise your call option, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share." If I have to buy the 100 share which I am assuming is a CASH transaction...so where is the leverage, I mean I still need to have enough cash to deal with this transaction, apart from options. Where is the leverage ? I see it only in acquiring the shares using option, but to close this loop I still need cash - isn't ?
you dont have to exercise your options into shares you can simply buy and sell the options itself compare to stock, you can gain and loss more significant money in options for each point of move in underlying (delta effect on options pricing)
The leverage expires with the option, so to speak. Buying an option and reselling the option before expiry is what you do, don't hold until assigned unless you actually wanted to buy it long term. Per your example, That $200 XYZ40 Call will expire worth $1000. Sell the call right before the close. That's a 400% gain on what was only a 25% move in the underlying. Buying 100 shares of XYZ cash would have cost you $4000, and made you $1000. You make 800$ with the option and 1000$ with cash, but that difference is the price you pay with the reduced risk of options.
By purchasing a call, you can benefit from the stock going up with a lower capital allocation. That is leverage. You are looking at the end of the option lifespan vs the leverage today. The leverage is gone at expiration.
thank you all - so I basically sell the option before expiry or take stocks if I want to hold even longer than expiry day. Now I sort of get it
That is not entirely correct. Options move always less in absolute terms than the underlying. Almost always anyways. It's the relative move, change in option price relative to the initial option premium, paid. That is also where the leverage comes from to answer OP
A trader - as opposed to an investor - would seldom hold the call until expiration. The trader (me) would consider the call to be simply a derivative of the underlying stock. If the underlying rises to my target price, I would look to take a profit in the option, which I can do at any time prior to expiration. The issue of leverage is simply that I can "control" more of the underlying stock, and therefor participate in more of its gain (and loss), by buying the call, rather than the stock itself. However, there is no free ride, and the advantage of the option comes at a price of increased transaction costs and time decay. In general, the best time to buy a call is when (1) You expect a sharp move in the stock, and you expect it to happen quickly, (2) The bid/ask spread on the option is reasonable and (3) You've for whatever reason decided that the option is a better play than simply buying the underlying stock. Because in most cases, if you feel the stock is going to move up, you are better off buying the underlying, and not dealing with the issues of spreads and decay in the options. Good luck.
the technical version of what you said is if you expect future realized volatility to be higher than implied volatility (implied by the option price) then you should choose the option over the underlying. There are a myriad other reasons why to choose one over the other but what I mentioned is an often overlooked fact.
worst trade possible -never buy far dated deep OTM calls in a market that has dropped-you will pay $$$$ for peanuts