SOME EASY EXAMPLES
Okay, so we’ve gotten the semantics out of the way now, so let’s look at some examples of purchasing the above call option contract with three different outcomes:
- Stock goes up
- Stock price doesn’t change
- Stock goes down.
Scenario 1: ABC goes up to $60 before the Expiry Date
In this case the option contract become “in-the-money”. Since you could sell shares of ABC in the open market for $60/share – it would make sense to exercise your option to buy the shares at $55/share and then immediately sell them for a $5/share gain. But, that being said, many people don’t actually exercise their option – rather, they just sell the option contract itself. The option contract’s price will fluctuate with the underlying stock’s value – and when the contract is in the money, the option contract’s price rises in lock-step. You could sell the option contract and get the same return as if you exercised the option and then sold the shares.
If ABC is trading at $60/share, then the Apr 55 Call will be trading for very close to $5. Remember you only paid $2.50 for it – so if you sold the option, you will have doubled your money (bought the option contract for $2.50 and sold it for $5.00 = a $2.50 gain x 100 shares = $250 gain). If you did it the hard way, then the math would look as follows:
You bought the contract for $2.50, which multiplied by 100 shares = $250 (cost)
You exercise your option so you buy 100 shares at $55 = $5,500 (cost)
You then sell your shares immediately for the market price of $60 x 100 shares = $6,000 (proceed)
$6,000 – $5,500 – $250 = $250
So the math on doing it either way is equivalent.
If you compare this to the regular method of being long a stock, your gain is not quite so spectacular. You might normally buy 100 shares of ABC at $50 dollars, and then just turn around and sell those shares at $60/share when they appreciate. Your initial outlay would have been $5,000 (100 shares x $50/share). Your sale proceeds would have been $6,000 (100 shares x $60/share). There was no premium paid for any contracts, so that’s it. You would’ve had a gain of $1,000 on $5,000 – or 20%.
Remember though, we have just looked at the “rosy” side of things – you need to weigh the options (pun totally intended) of the various different outcomes as well… so let’s do just that!
Scenario 2: ABC stays at $50 up to the Expiry Date
In this case, the April 55 Call would be “out-of-the-money”. The value of the option would slowly dwindle down to ZERO by the expiry date. The reason it has any value at all during this time is due to the fact that the further away we are from the expiry date, the more chance there is of ABC getting to its strike price. This is actually known as the TIME VALUE OF THE OPTION.
Warning: Tangent Beginning…
Actually, now is a good time to make a segway about the pricing of options. The price of an option is made up of two components:
- The Time Value of the Option
- The Intrinsic Value of the Option.
The Intrinsic Value of the Option is quite easy to calculate. It is simply the difference between the underlying stock’s price and the strike price whenever the option is “in-the-money”. So if ABC were $60 – the intrinsic value of the option is $5. Simple as that.
The Time Value of the Option is a *bit* more tricky. You see, you can’t really quantify the time value of the option in and of itself, but you can figure it out based on the difference between the option contract’s price and the intrinsic value of the option. So if the option contract is priced at $5.50 (when you own an Apr 55 Call on ABC and ABC is $60/share) then you know the intrinsic value is $5 – therefore the time value is $0.50. If you bought the Apr 55 Call contract on ABC when ABC was AT-the-money (i.e. the strike price is the same as the share price) and the price of the contract was $2.50, then $2.50 would be the time value of the option. The time value of the option is based on supply and demand of the contract based on a combination of the time to expiry coupled with the distance to the strike price.
Okay, so back to our example, if ABC never appreciates (or in other words, never gets to the strike price) then the option contract will expire worthless! That means that you are out the $2.50 contract premium you paid and you have lost 100% of your money or $250 (100 shares x $2.50)!
Compare this to just going out and buying the 100 shares for $50/share and then selling them for $50/share. You spent $5,000 and got back $5,000 (well, I suppose you would be out a few bucks for commissions, but for the sake of our argument – let’s omit commissions for now). In this case you still have your entire principal.
So – all of a sudden, the world of options is losing some of its luster, n’est-ce pas?
Scenario 3: ABC goes down to $40
Well, by now you should realize that unless ABC is in the money by the expiry date of the option contract, the option contract will expire worthless no matter what. So you still have lost 100% of your money by buying the Call Option Contracts in this case. It doesn’t matter if ABC becomes delisted – you can only lose 100% of your money when buying a Call Option Contract.
But for the investor who goes out and buys 100 shares of ABC at $50/share and then sells them for $40/share, they will have lost $1,000 on their initial $5,000 outlay – for a total loss of 20%.
But while a 20% loss sounds better than a 100% loss – in this case the option contract holder only lost $250 while the traditional method yielded a loss of $1,000. So the absolute loss is greater than with the traditional method in this case.
Okay, so now you have seen the mechanics behind how call options work. I think I have presented a balanced view of how they can work (or backfire) for an investor. So who buys options? Well there are two main reasons for buying call option contracts.
- High potential leverage – when a stock only has to appreciate by (in the example case) 20% to yield a 100% return on your money – well that’s quintessential leverage isn’t it?
- Limited Risk – Maybe that sounds paradoxical when you can lose 100% of your investment, but consider the absolute value of the loss can be small (the value of the contract purchase) which in our sample case was $250.
If you have a very good idea that a stock is going to appreciate, buying an option allows you to leverage your long position in that stock for a quick and large gain.
Part 3: Call Option Writing
You may have thought that we've finished, but we have one more article coming up on SELLING call options (writing). Stay tuned!If you would like to read more articles like this, you can sign up for my free weekly money tips newsletter below (we will never spam you).