How Call Options Work I – The Basics
Preet, the full time Bay Street stock broker and blogger at WhereDoesAllMyMoneyGo, has written another great article for MDJ about How Call Options Work. I initially planned to write the article, but thought it would be best to have an article from a trader experienced with the ins and outs of options. This is Part 1 of a 3 part series.
Thanks again to Frugal Trader for asking me to create a guest post for his readers. I was asked to create a primer on call options this time – so here is my shot at it – I hope you find it informative!
The first thing to note is that OPTIONS when used in the context of CALL and PUT OPTIONS are different from EMPLOYEE STOCK OPTIONS which are issued by companies to their employees. EMPLOYEE STOCK OPTIONS are an employee benefit that represents the ability to purchase treasury shares right from the company at a specified price for a specified period of time (usually 2 years or thereabouts). This post is not about employee stock options.
No, this post is about the “other” type of options – of the CALL option and PUT option varieties. Options are both a very simple concept and at the same time a very versatile and complex portfolio management tool. There are very conservative option strategies and VERY risky option strategies. More press is given to the riskier strategies unfortunately, and quite frankly I think most investors should explore the use of the more conservative options strategies for their own portfolios as I will attempt to show. Every time I explain some simple option strategies to investors, eyebrows are raised and questions are asked… There just isn’t enough information and investor education on options out there.
Let’s begin by talking about Call Options today. Options are a type of “derivative” – and a derivative is a security “whose value is derived from the value of something ELSE”. What it means in this case, is that when you purchase a call option on a stock – you haven’t actually bought the stock, but the value of the option is related to the value of that “underlying” stock. I’ll spare you the academia from this point on and just get right to the nitty-gritty… J
When you buy a Call Option, you are buying the OPTION to purchase a stock in the future for a set price, for a set period of time. This would be advantageous if you thought the stock was going to go up in the future. Also of note, is that call options provide for a degree of leverage (allowing you to increase your potential returns) and also limit your potential losses.
Let’s examine a typical Call Option quote on the stock ABC, which has a current stock market price of $50:
|Option Type||Security||Expiry||Strike Price||Premium|
Reading from left to right: This quote is for a CALL OPTION on the security ABC. The option contract EXPIRES IN APRIL. The STRIKE PRICE of $55 is what the option holder can purchase the shares of ABC for anytime up until the 3rd Friday of April. To purchase the ability to do this would cost the option holder $2.50 per contract per share.
Not quite as easy as a typical stock quote and certainly some quirks too! Probably the thing that sticks out most is that all options expire on the third Friday of the month listed. That means the option holder has the ability to exercise their option up to AND including the third Friday of the month – otherwise the option expires on the Saturday.
The second thing that I want to point out is the “strike price”. If you were to purchase this option contract, you would have the option of buying 100 shares of ABC for $55 per share, no matter what the stock was trading at. Obviously it would make no sense to “exercise your option” and purchase shares of ABC for $55 today when they are only trading for $50 on the open market. If, on the other hand, ABC was trading at $70 before April, you could still buy it for $55 since that is the option you have bought. Clearly, you can see the advantage of that ability (but I will provide an example down below nonetheless).
Thirdly, note that I mentioned the quantity of 100 shares. Each option contract is specified for 100 shares of the underlying stock. So even though the premium (the price to buy this Call Option Contract) is $2.50 – your outlay will be $250 ($2.50 x 100 shares).
Fourthly, when the value of the underlying stock starts trading ABOVE the Strike Price, the option contract is said to be “IN-THE-MONEY”. When the stock price is equal to the strike price, it is “AT-THE-MONEY”. And finally, when the stock price is BELOW the strike price – the option is “OUT-OF-THE-MONEY”.
Option contracts would be used as followed in financial parlance: I own an April 55 Call on ABC.
Part 2: How Call Options Work – Examples
Part 3: Call Option Writing