What is a call option, and why should you know about them? A call option is a investment tool used to in essence bet on the price of a stock in the future – read some more details about this type of transaction here. People buy and sell these because they can get a huge return for a small investment or receive small payouts for holding shares of a company with the risk of having to sell the stock at a certain price.
Simple example below for buying a call option using real prices as of today.
You buy a call option for Google that expires the middle of next month (October 19th, 2013). The strike price for which you buy the option is $900 and you pay $14.60 per share for the option (options are bundled into stacks of 100 shares so you will pay $1,460 total). The person who sold the option to you immediately receives around $1460 for their holding of 100 shares currently valued at $860 per share or $86,000. This means they immediately get almost 1.7% of their entire holding of the stock in cash.
Why would anyone pay $1460 for this option? See the three example outcomes below:
Google goes up to $950 by October 19th – the buyer of the call option will receive $50 per share for his option ($950 – $900). That means he will have made $5,000 minus what he paid for it ($1,460) for a total of $3,540 in profit. That equates to more than 340% returns on investment, a hefty profit indeed. The seller of the option will be forced to sell the stock at $900 per share, so he is losing out on $5,000 but still has to consider what he made from writing the option ($1,460) which puts him at losing the potential $3,540. Luckily, he is still making money since the stock has risen above $860 so he makes $40 per share plus the price he wrote the call option for totaling $5460.
Google remains at $860 by October 19th – the buyer of the call option loses everything, since the option did not reach the strike price. The writer of the option keeps what he made from writing the call option ($1,460). The writer also does not need to sell his stocks.
Google plunges to $500 per share – the buyer of the call option is only out what he put in ($1,460). The writer of the call option did not sell his shares since he has a option on his holdings and doing so before he buys back his call option puts him at infinite risk. He gains $1,460 more than if he had held the shares and not wrote the option, but has lost $36,000. His total losses are $34,540.
Now, consider the optimal situation for the writer of the call option – The stock climbs to $949 per share before expiration, a dollar short of the strike price. If this happens the seller can go ahead and write another call option for the same shares for the next month!
The optimal situation for the buyer of the call option is for the stock to skyrocket of course, so he can make profits on his investment.
The lose-lose situation is if the stock plummets, although you may argue that the writer of the call option still comes out better than if he didn’t write the call option if he was going to retain the stock either way.