Over the next two weeks I will be informing you about the two most basic options that are available in the options market. Calls and puts are very easy to understand and when used correctly can potentially bring big gains. They can also be combined in many different ways in order to create options strategies such as the ones I have discussed in previous posts. I previously discussed butterfly spreads, bull call spreads, protective puts, and covered calls. These are all very interesting strategies, but what is behind all of them? Basic puts and calls! Today I will be focusing on calls.
Call Options:
A call option is an agreement that gives the investor the right to buy a stock at a specified price at a specified time (or time period). You can either buy a call, or sell a call. We will start with the basic action of buying a call. When you buy a call, you are agreeing to buy the right to purchase a certain amount of stocks at an agreed upon price once a certain at a certain time. However, as the investor you do not necessarily have to buy the stock at this time. You have the right to buy the stock for this price, but it is not an obligation. Say for example, that the current price of SolarCity Corporation is $70. An investor who believes that the stock is going to rise in price by a lot could agree to buy a call option. He could potentially buy a call option on SolarCity at $80 for October 2014. Once October rolls around, the investor has the right to either exercise his option and buy the stocks for $80 or not exercise.
When would he exercise and when would he not?
If the stock price is over $80 the investor would exercise his right and buy the stocks. He would do this because he would be paying $80 per stock even though the value is higher than $80. His profit from exercising the options would then be the difference between the price he paid and the current value multiplied by the amount of stocks (One call = 100 stocks). For example if the price was at $88 and he had purchased 10 call options (1000 stocks), then his profit from the purchase of the stock would be ($8 times 1000 =) 8000 dollars. If the price was below $80 dollars, the options would not be exercised because it would not make financial sense to do this.
Why doesn’t everyone buy calls? It seems risk free!
Because the market is how it is, somebody has to win and somebody has to lose on each transaction. Therefore, there always has to be a way to lose money with each transaction if there is a way to lose money. When somebody buys a call, they pay what is called a premium. This is an upfront payment which allows the investor to obtain this right to buy the call. The seller of the call in this case would receive an inflow of money when the transaction is agreed upon. Because of this, the $8000 dollar profit we discussed in the previous passage would not be the final profit. You would have to subtract the initial cash flow (premium) from the profit to determine how much was really made. If the option was not exercised, the buyer of the call would not pay anything else, and would have a loss based on the initial premium they paid. In this case, buying a call at $80 on SolarCity would cost the investor a premium of $5.60 a share, or $5600 overall. Thus if they exercised the option at $88, there profit would be $2400 whereas if the price ended up below 80 and was not exercised, they would end with a loss of the initial premium of $5600.
Selling a call-
Selling a call has the opposite effect of buying a call. We will use the same example to demonstrate this. If I was an investor and had sold the 10 call options to the investor above, my cash flows would be opposite of his. If the price stayed under $80 I would gain the premium that he paid me of $5600. If the option was exercised at $88, I would lose $2400. For both sides of this contract, the breakeven point would be at $85.6 dollars. Every dollar after $80 would result in a loss of $1000 for the seller of the call and a gain of $1000 for the buyer of the call.
Why buy or sell a call?
People buy or sell calls for a couple of reasons. We will start first with selling calls. When you sell a call, you have the option to receive a quick boost of income. If you do not believe the stock will go up, then this could be a great way to take advantage of the possible decline of a stock. It could also benefit you if the price is not expected to go up much. For example, selling a call option on the previous example could be very profitable. If the price stays below $80 by October, the seller of the call would have gained $5600. Even if the price reaches $85.60 he/she would still break even! For the buyer, buying calls is a great way to take advantage of options if you do not have as much money but believe the price will go up. Because the premium is so high in this example (SolarCity has great prospects), this may be a dangerous play for the buyer. However, if the premium was more reasonable or the price was expected to go up much higher, then this could be a good option to buy, To show this, I will compare buying ten calls (1000 stocks) for $5600 to buying $5600 worth of shares. This would only buy you 80 shares. If the price rocked to $100, you would gain (100-70) $30 times 80 ($2400) if you held the shares. Alternatively, with the call options you would gain (100-80) $20 times 1000 (shares) or $20,000. Your gains would be nearly ten times larger with options. There is a slight risk of losing money based on the premium, but if you purchase the right calls at the right time, you can make massive gains off of call options.
I hope that this post has helped you to understand call options, but just to make sure I have added a graph which shows both the profits for buying a call and selling a call. Keep in mind that a long call means buying a call, and a short call means selling a call.
As you can see, the profits are the inverse of the other.