Let us examine the use of the call option in the financial markets. The example below is based on the purchase of a call option on a stock, but the concepts of the call option are the same with whatever financial instrument is used.

First, a quick review of the call option.

A call option is the right to buy the underlying asset at the strike price until the option expires.

Since the Call option gives the right to buy the stock at the strike price, a call option is used when the price of the stock is anticipated to rise. The following example will help to explain why the call option increases in value

In this example, the purchase of an AAPL APRIL 120 Call is discussed. This gives the option buyer right to buy 100 shares of Apple Inc. (AAPL | news | PowerRating | PR Charts ) at a price of $120.00 a share. This right exists until the close of trading on the 3rd Friday of April, the expiration date for April options.

Let's say that the decision to buy the call option was made on March 3, 2008. AAPL closed at $121.73 We will assume that call is purchased at the last trade price. The option purchase price is known as the premium.

In the case of the APPL call, the quote was $9.50 This quote has to be multiplied by 100 to give us the final price of the option. In this case, the option premium would be $950.00.

The option buyer now has control of 100 shares of AAPL stock for a total price of 950.00.

This is much less than purchasing 100 shares of AAPL, which would cost $12,200. It is even less expensive that if a trader was able to use 50% margin, putting up only $6,100.00.

For the buyer of the call option AAPL, the maximum that can be lost is the cost of the option: $950.00.

Since the option gives the buyer the right to buy the stock at 120.00, any time the stock price is over 120.00, the option is considered "in the money".

And when the price of the stock is greater than the call strike price, the difference is called "intrinsic value". This means that if AAPL's current market price is 130.00. The intrinsic value would be $10.00 per share.

The math for this concept looks like this:

AAPL's Market Price = $130.00

The Call Strike Price = $120.00

Call's Intrinsic Value Per Share = $ 10.00

If the market value of AAPL goes to $140.00, the intrinsic value of the option would be $20.00 per share. The option's value would theoretically be $20.00 x 100 = $2000.00

There are other factors present in determining the value of an option over the life of the option, but those factors will be discussed in later articles.

The premium paid for the option must be included when calculating the potential profit or loss on the purchase of the call option. Since the premium paid for the option was $9.50 per share, this value must be added to the Call strike price to determine the break even price of AAPL. The math for this breakeven point looks like this.

The Call Strike Price = $ 120.00

Premium Paid Per Share = $ 9.50

Stock Break Even Price = $ 129.50

With all of this in mind, what happens when AAPL closes at 149.53 on April 1, 2008?

For one, the Intrinsic value of the call has increased dramatically:

AAPL Market Price = $ 149.53

The Call Strike Price = $ 120.00

Call's Intrinsic Value per share = $ 29.53

The original premium of $9.50 a share ($950.00 total premium paid) is now worth $29.53 a share, or $ 2953.00 value.

The option has increased in value by $20.03 per share ($2003.00 total increase). Using leverage resulted in a return of 211% over 20 trading days.

The total dollar return on the purchase of the stock would have been higher since the stock could have been purchased for $121.73 and sold for $149.53. The total dollar return would have been $27.80 a share or $2,780. The return over the same 20 days doing an outright purchase would have been 23%.

If APPL stock had not gone up in price over this time, but instead had fallen to $100.00 a share, the maximum loss on the option could still not exceed the original $950.00 premium paid. Purchasing the stock for cash would have resulted in a loss in value of $2100.00.

This is just one example of a call option purchase. The results reflect the actual change in Price in AAPL stock during the period of March 3, 2008 to April 1, 2008. The actual prices of the option varied slightly but not enough to change the results shown in the examples.

John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis. A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies. Emery uses options both to trade and as a risk reduction tool.