If you are brand new to options, or you do not quite yet understand how they work, I strongly encourage you to read my previous article, linked below, which is an easy read, aimed to help you visualize the concept of options by illustrating their presence outside of the financial world.
If you do not feel like reading my previous article here is a summary:
An option can be comparable to buying/selling a house. When in the market, a buyer may put down a deposit to hold the house for a certain number of days, for a specified price. In this example, the buyer has the right to buy the house at the predetermined price, by a certain period of time, or they will lose their deposit (essentially breaking their contract).
With this illustration in mind, an option as a financial instrument, can further be defined as a right (for the buyer of a contract) to buy a stock at a predetermined strike price, within a certain amount of time. The time factor being defined as the option expiration date.
My previous article defines the option price, strike price, and expiration in further detail, but in this article, my goal is to use the same analogy mentioned above to define a call, and further explain the buyer side of an option contract.
Buying a Call
In the analogy above, buying a house is similar to buying a call, and lucky for you, this is one of the easier concepts to understand. Before I dig a little deeper into this concept, let me define a call option:
a contract which gives the owner (of the contract) the right to buy a stock.
Okay cool, so now- what the hell does that definition mean? Let me go back to our housing analogy:
Putting down a holding deposit of 5k for the right to buy a house at 500k, within a certain period of time is the SAME concept as buying a call option for $1 for the right to buy a stock at $50, within a certain period of time.
Note!!! When you buy a call option, you are buying the right to purchase 100 shares of stock. This means that the real cost of the option is $100 ($1*100).
1. The value of the house goes up
Imagine that after putting in an offer of 500k, the local government decided to build a school nearby, increasing the value of the house to 550k. Would you still buy the house at 500k? Absolutely! Now, keep in mind that you paid 5k for this contract.
Profit Calculation:
predetermined price of house+ cost of contract
500k+5k
=505k
market value of house- 505k
550k-505k
=45k
This reveals that the value of the house not only has to rise, but that it has to rise by more than what you paid for your contract.
OR- The stock price goes above strike price
Similar to our house example, you will make money by buying a call option when the stock price goes above the chosen strike price by more than the price you paid for the option contract. Our strike price is the predetermined price of the stock- $50. Assuming you hold your contract until expiration, at what stock price will your option be profitable? Calculation below:
stock price+ option price
=50+1
=$51
Still confused?
Let me illustrate this with a concept easier on the mind:
Imagine you bought a coupon for $1 which allowed you to buy a tv for $50. This coupon would only be worth the buy if the store raised the price of the tv from $50 to more than what you bought the coupon for. Call options should be seen with a similar mindset.
Main Point– To make money through buying a call option, the stock price not only has to go up, but the stock price has to move up enough to compensate for the price of your option.
2. The value of the house goes down
Now imagine that after putting in an offer of 500k, the local government decided to build a dumpster nearby, decreasing the value of your house to 450k. From an investment standpoint, would you still buy the house for 500k? Absolutely not. In this scenario you would incur a loss of 5k (your deposit) and put your money elsewhere.
OR- The stock price goes below the strike price
If stock price goes below the strike price, your option loses value and is essentially worthless. Going back to our coupon example:
If you have a coupon to buy a tv for $50, and the store lowers the price to $45 will you still use your coupon? I hope not.
Main Point: If the stock price is below your strike price by the end of expiration- you lose money.
3. The value of the house stays the same
If the value of the house stays the same, you may think that you would just breakeven on this investment. BUT, Remember from the first scenario that the real price of the house is 505k. If the value of the house stays at 500k, but your cost of buying the house is 505k, you can see how this loss will be incurred.
OR- The stock price is equal to your strike price
While the above scenario is a little confusing, hopefully we can clear this concept up. If you buy an option contract for $1 and you have the right to buy a stock at $50 and stock price does not move at all, you have still paid $1 for that contract, and in other words have incurred a loss of $1 (or your deposit).
Explained in our coupon example:
If you paid $1 for a coupon to buy a tv for $50 and the store keeps the price at $50, will your coupon save you any money? No, AND you just wasted a dollar on your worthless coupon.
Main Ideas
While there are MANY details that go into buying a call option, this article was aiming to help you understand the underlying concept of this option strategy. If you learn anything from this article:
- You make money when the stock price surpasses your strike price by more than what you paid for your option
- You lose money when the stock price goes under your strike price
- You lose money when the stock price stays the same as your strike price
After reading this article, you may be wondering why in the world anyone would buy a call option.. Seemingly, you lose money in 2 out of 3 scenarios. I wonder the same thing. However, you must understand that the prices alone are not the only factors that determine an options value, and these scenarios are based on an assumption that we hold the option until expiration.