What are Call Options?
Call options are a financial derivate that gives the buyer the right, not the obligation, to purchase 100 shares of stock at a set price, known as the strike price. Options contracts have a writer (seller) and a buyer. The writer specifics the strike price and the expiration date. The writer then receives a premium for their contract that they are always entitled to.
If a call option is “in the money” the strike price is at or below the market price of the stock. If a call option is “out of the money” the market price is higher than the strike price. Traditionally, buyers of call options tend to buy contracts that are out of the money due to a thesis revolving around the stock price appreciating in the near future and moving into the money.
What makes option contracts interesting is time. The writer specifies how long the buyer has the option to purchase 100 shares. The buyer can execute at any time within the expiration date as long as the option is in the money.
Here is an example:
Levi purchases a $95 call option for stock ABC that expires in 6 months. Within the first two weeks, stock ABC increased to $103. Levi has found himself in a great situation, his contract is in the money. Levi now has the right to buy 100 shares of stock ABC for $95 per share. Levi has a capital gain of 8.4% if he decides to execute the option. It is to be noted that Levi’s profit would not be 8.4% or $800 ((103-95)*100) as he paid a premium for the option that he will not get back.
Using the same situation, if Levi decided not to exercise his option after his option was in the money, and stock ABC depreciates to $90 he can not execute his contract at the moment. If the depreciation trend continues until the end of the expiration date, Levi’s contract is deemed worthless, he loses his ability to exercise the option and the writer keeps the premium.
Risks of Call Options
Buyer Risks: A benefit to purchasing options as opposed to being long or short a stock, is the buyer has a set risk. The buyer can only lose the premium that was paid for the option.
call options lose value when the stock is falling (exceptions to extreme volatility) or when a stock is consolidating. When an option is losing value due to consolidation, it is known as Theta Decay, meaning the expiration date is approaching and the value of time is diminishing. The graph on the right displays time decay. As options near expiration, they lose value. This is why purchasing options that expire in less than 30 days tend to be much riskier.
Seller Risks: There are two ways the writer/seller of an option contract can sell a call option. The writer can sell what is known as a covered call, meaning the writer owns 100 shares of the option they are selling. A writer can also sell a naked call, meaning the seller does not own 100 shares of the option that is being sold.
Naked calls are quite risky and advised against. In theory, a stock price could go to infinity. This risk is best displayed in an example.
Alexa wants to collect a premium, so she decides to sell a call option for stock ABC for $3 a share or $300 (100*$3). She writes a three-month expiration with a strike price of $90. At the time of writing the contract, stock ABC trades at $80. However, a month after the contract was written, stock ABC reported earnings and crushed their top-line revenues. This drove the stock price up 35% to $108. The buyer of the option decides to exercise their right. Now, Alexa has the legal obligation to sell 100 shares of stock ABC to the buyer, however, the issue is Alexa has to buy shares in order to sell them. Alexa buys 100 shares at $108, totaling $10,800, then immediately sells them to the buyer for $9,500. Alexa’s net return is $9,500+$300-$10,800= $-1,000.
Analogy
Buying a Call Option is like placing a bet. For whatever fundamental, technical, or positioning reason, the buyer believes the stock will increase in value from the purchase date to the expiration date. This is like placing a future on the Kansas City Chiefs to win the Super Bowl due to reasons such as excellent quarterback play, a schematic edge, or believing in their personnel. Similar to a call option, the bet does eventually expire.
Conclusion
Trading options can get intricate, and call options are only the tip of the iceberg. However, it is important to understand financial derivates and have them at your disposal to utilize in certain environments. Future blogs will be published explaining when to use options for your portfolio.
