A call option represents the right to buy an underlying asset for a specific price through an expiration period. One single stock call option, for example, is the right to buy one hundred shares of stock. The premium paid for the calls is often a fraction of the cost of the actual shares. This is known as leverage.
Another analogy can help demonstrate the important concept of leverage. Let's say you have $500 of your own money and borrow $4,500 from Uncle Bill to invest in a sailboat you intend on fixing and selling next summer. Bill expects some sort of compensation for the loan and agrees to give you the money if you repay him $4,700 once the boat is sold.
Twelve months later, you have completed the necessary improvements and repairs. You sell the boat for $5,500, and total profit is the sale price ($5,500) minus the money you invested ($5,000), or $500. Of that, Uncle Bill received $200 (on his $4,500 investment), while you received $300 (on a $500 investment). Stated differently, you earned a 60 percent return on your $500 and did much better than the 4.4 percent return Bill earned on his $4,500. The leverage ratio in this case is nine-to-one, because you borrowed $9 for every $1 you invested of your money.
Now what happens if the boat sells for less than expected? For instance, at the end of twelve months, let's say the best you can get for the boat is $4,700. In this case, you repay Bill $4,700, according to the agreed upon terms. ...