Imagine having the power to buy a ticket to a blockbuster movie at a discounted price and then sell it later at a higher price, keeping the difference as profit. That's essentially what a call option allows you to do in the world of finance. But what exactly are they, and how do they work?
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What is option trading / call & put option?
Option trading is a dynamic and fast-paced method of trading that offers traders the potential for quick profits or losses. However, understanding the fundamentals of option contracts is crucial to effectively navigate this financial instrument.
Options trading is an advanced strategy that allows investors to engage in stock market activities, manage risk, and strategically plan their investments. To become an option holder, it is essential to comprehend the distinction between the two types of investment options: put options and call options.
Call options explained
A call option is a contractual agreement that grants investors the right, but not the obligation, to buy securities such as bonds, stocks, or commodities at a specified price, known as the strike price. This option contract also has a defined expiration date, referred to as the strike date or expiry date. Buyers pay a premium for the call option, anticipating that the price will increase within a specified timeframe.
A call option contract typically involves 100 shares and expires after the exercise date. Depending on their expectations of the underlying asset's price movement, investors can either sell or buy them. The decision to exercise the option or let it expire rests with the buyer.
It's important to note that as a buyer of a call option, you have no obligation to exercise it. If the share price rises, you can choose to sell or execute the contract. If the price fails to increase, you may allow the contract to expire, resulting in the loss of only the premium paid.
On the other hand, if you are the call writer or seller, you sell call options to receive the premium. However, your income is limited to the premium alone. There are two ways to sell call options:
- Naked call option: This involves selling a call option without owning the underlying asset. If the buyer exercises the call option, you must purchase the asset at the market price. However, you will incur losses if the price is higher than the strike price.
- Covered call option: In this scenario, you sell a call option for an asset that you already own. Ideally, the buyer would exercise the option when the strike price is higher than the original purchase price of the asset.
When dealing with call options, there are three important terms to be familiar with:
- In the money: The underlying asset's price is higher than the call strike price.
- Out of the money: The underlying asset's price is lower than the strike price.
- At the money: The price of the underlying asset is equal to the strike price.
An example of call option
Suppose you are an investor interested in a technology company called XYZ Inc. Its stock is currently trading at $50 per share, and you believe the price will increase in the next three months. You make a decision to purchase a call option on XYZ Inc. with a strike price of $55 and an expiration date three months from now.
By buying this option, you secure the right to buy 100 shares of XYZ Inc. at $55 per share within the next three months. You pay a premium of $2 per share, totaling $200 for the entire contract (100 shares x $2 premium).
Now, there are two possible scenarios:
- If the price of XYZ Inc. rises above $55 within the three-month period, let's say it reaches $60 per share, you can exercise your call option. This means you can buy 100 shares of XYZ Inc. at the strike price of $55, even though the market price is $60. You can then either sell the shares at the market price of $60 to make a profit or hold onto them for potential further gains.
- However, if the price of XYZ Inc. remains below $55 or does not rise significantly during the three-month period, you have the choice to let the call option expire. In this case, you would lose the premium paid ($200), but you are not obligated to buy the shares at the strike price.
Remember: The profitability of a call option depends on the movement of the underlying asset's price. If the price doesn't reach or surpass the strike price, the call option may result in a loss due to the premium paid.
How to calculate call option
Determining the outcome of a call option trade involves a calculation based on various factors. To assess your potential profit or loss, follow these steps:
Start with the price of the underlying security and deduct the option premium, strike price, and any applicable transaction fees to calculate the intrinsic value, which represents the potential profit or loss.
Underlying Security Price - (Option Premium + Strike Price + Other Transaction Fees) = Intrinsic Value (Profit/Loss)
For example, let's consider a company with a $100 exercise fee, a $10 premium, and a $1 transaction fee. Assuming the call option contract covers 100 shares, the total premium cost would amount to $1,000.
$10 (premium) x 100 (shares) = $1,000 reward
In this case, the breakeven point would be $111. This includes the $100 strike price plus the $10 premium and the $1 transaction fee. To avoid a loss, the company's shares should be valued at least $111.
If the price of the company's shares reaches $130 before the specified date (e.g., November), your earnings would be $19 per share. Multiplying this by the 100 shares covered in the contract, the total profit would amount to $1,900.
$130 (price of underlying security) - ($10 option premium + $100 strike price + $1 transaction fee) = $19 earnings per share
$19 (profit) x 100 (shares) = $1,900 total profit
Pros & cons of call options
| Advantages | Disadvantages |
|---|---|
| 1. Potential for significant profits: Call options may yield substantial gains if the price and value of the underlying stock rise significantly before the expiration date. | 1. Premium loss if stock price falls: If the stock market closes below the strike price on or before the expiration date, the call option buyer loses the premium paid for the option. This means that if the expected price increase does not occur, the buyer incurs a loss in the form of the premium. |
| 2. Low upfront cost for call buyers: Call option buyers may enter the market with a relatively small upfront cost (the premium) while having the potential for significant gains until the option expires. | 2. Limited income for call sellers: While call option sellers receive the premium as income, their potential profit is limited to the premium received. If the stock price rises significantly above the strike price, the seller misses out on further gains. |
| 3. Risk-free income with covered call options: By employing a covered call strategy, investors may generate income from call options while holding the underlying stock. This strategy may provide a risk-free way to make money from the premiums received. | 3. Unlimited potential losses with naked call options: Naked call options refer to selling call options without owning the underlying stock. This strategy exposes the seller to unlimited potential losses if the stock price rises significantly above the strike price. The seller may be required to purchase the stock at a higher market price to fulfill their obligations, resulting in substantial losses. |
Put options explained
A put option is a contract that grants an investor the right to sell a stock at a specific price within a given timeframe. This type of option is typically used by investors who anticipate a decline in the price of the underlying stock. The predetermined price at which the put option holder can sell the stock is referred to as the strike price.
When the stock price decreases, the value of put options increases. In such cases, the option holder can choose to sell the put option. However, if the stock price does not decline as expected, the option holder has the option to let the contract expire.
It's important to note that the breakeven point for a put option is the difference between the strike price and the premium paid for the option. This is the point at which the option holder neither incurs a profit nor a loss.
Example of put option
Let's illustrate a put option example. Suppose the current trading price of XYZ shares is $400 each. If you believe the stock is overvalued, you can purchase a put option with a strike price of $350 and a three-month expiration period. The premium for this put option is $10 per share, resulting in a total cost of $1,000 when multiplied by 100 shares.
Calculation of put option
To compute the intrinsic value of the put option mentioned in the previous example, you would perform the following calculation:
Strike price of $350 - Premium of $10 = Breakeven point of $340
In this case, the breakeven point is $340. If the price of XYZ shares declines to $300, your potential profit would be $40 per share, resulting in a total profit of $4,000 for your put option. However, if the stock price does not decrease to $350 or below, you have the option to let the premium expire without further action.
Pros & cons of put options
| Advantages | Disadvantages |
|---|---|
| 1. Potential for decent returns in falling markets: Put options may generate favorable returns when market prices decline below the strike price. If the stock price falls significantly, the put option holder may profit from the price difference. | 1. Possible loss of premium: If the stock price rises or remains the same, the put option buyer risks losing the premium paid for the option. In such cases, where the expected price decrease does not occur, the premium represents a loss. |
| 2. Lower risk in a volatile stock market: Put options could be advantageous in volatile market conditions, as a falling price could mitigate risk. In such scenarios, the put option serves as a means of protecting against potential losses. | 2. Higher premium compared to call options: Put options typically have higher premiums compared to call options, which may increase the upfront cost for the option buyer. This higher premium is attributed to the added risk protection provided by put options in falling markets. |
Conclusion
It’s important to note that options trading involves inherent risks, and there are no guarantees of profits. It's essential to exercise discipline, patience, and continuous learning as you navigate the world of call options.
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FAQs
1. What is a call option?
It is a financial contract that gives the holder the right, but not the obligation, to buy an underlying asset (such as stocks) at a predetermined price (strike price) within a specified timeframe (expiration date).
2. How does a call option work?
When an investor buys a call option, they are essentially purchasing the right to buy the underlying asset at the strike price before the option's expiration. If the market price of the asset rises above the strike price, the option becomes more valuable, and the investor can choose to exercise it and buy the asset at the strike price.
3. How is the value of a call option calculated?
The value of a call option is influenced by factors such as the price of the underlying asset, the strike price, time remaining until expiration, volatility, and interest rates. Commonly used models, such as the Black-Scholes model, can estimate the theoretical value of a call option based on these variables.
4. What are the advantages of call options?
- Potential for significant profits if the price of the underlying asset rises.
- Limited upfront cost (the premium) for call buyers, offering the opportunity for substantial gains.
- They may provide income generation for call sellers, who receive the premium.
5. What are the disadvantages of call options?
- The premium paid for the option is at risk of loss if the price of the underlying asset does not rise as anticipated.
- Call sellers have limited profit potential, as their income is capped at the premium received.
6. Are call options suitable for everyone?
They involve risks and complexities, making them more suitable for experienced investors who understand the associated risks. Novice investors should consider thorough research, education, and consultation with financial professionals before engaging in call option trading.
7. How can I mitigate risks when trading call options?
Implementing risk management strategies is crucial. Setting stop-loss levels, diversifying your portfolio, and managing position sizes may help mitigate potential losses.
8. Are there alternatives to call options?
Yes, put options offer an alternative perspective. Put options grant the right to sell an underlying asset at a predetermined price, providing potential profits if the asset's price decreases.
