A call option is the right, but not
the obligation, to buy a stock at a certain
price. To a stock owner,
this means a guaranteed income!
And to a buyer, it means
the possibility of netting a tidy
sum.
With a call option, the buyer pays for the right to buy a stock at a
certain price, at a certain point in time. Let’s say that a
person believes a stock will be €5 in three months’ time, they can buy the right to buy that stock at €4 instead.
Of course, if the stock is only at €3.50 at that stage, this right is worth nothing – and they don’t have to buy the stock since they are in no
obligation to do so. On the other hand, if the stockdoes actually hit €5,
they are able to buy it for less than the market
price!
How
does a call option work?
A call is an agreement regarding two things:
– a strike price:
the locked-in price of the stock,
– a strike date:
the agreed-upon date at which the sale will happen, if the buyer decides to go ahead and buy
the stock.
And this agreement has a price:
to lock in the price of the stock, the buyer agrees to pay a premium,
whether or not they buy the stock in the end.
So the buyer buys two things:
– the right to lock in a certain price
– and then the actual stock at that particular price, if they still want to buy it at the
strike date.
So, in a nutshell,
this is what a call option is: Person A buys the right to buy a stock
at a certain price from
Person B. The right to buy the stock at a previously
agreed upon price is a call option.
The price that the potential buyer pays to lock
in the stock price is the premium.
Who
would want to buy a call option?
Let’s say a stock is looking good,
the company offering that stock is healthy and doing very well.
A buyer might be interested in that stock,
but for whatever reason (they don’t have the money right now to buy the number
of stocks they want, they want to wait and see, or they have some other
strategy), they decide not to buy the stock right now.
At the same time they believe that there is a high probability that the stock will go up,
and they have a mind to buying it in the
future. Tomitigate the
disadvantage of buying the stock later for more money than if they bought it today, they can resort to calls.
On the other hand, if the stock doesn’t actually go up in price, they may not want the stock at all! As a result, they just want the right, but not
the obligation, to buy the stock at a certain price.
Their problem is that they don’t know how much the stock
will cost when
they actually get around to buying
it. What if it skyrockets?
Wouldn’t you be irritated to have to shell out €17 for a stock
that only three weeks ago was
trading at €10?
But for whatever reason you couldn’t or wouldn’t buy the stock
three weeks ago. And you have to pay an extra €7 for not buying the stock earlier –
unless three weeks ago you had the good sense of buying a call!
So the potential buyer enters an
agreement with a
person who holds that stock. The stock is currently trading at €10. They decide
to pay the stockholder €1 to be able to buy the stock at €14 in six months’
time.
And
what’s in it for the stockholder?
The stockholder makes both an income:
the price of the premium; and a profit:
if and when the potential buyer buys the stock from them, the buyer will buy it
at a price higher than the stock is currently trading.
If I hold a stock that is currently trading at €10,
and I sell a call option to sell that stock at €14 at a later date,
on the condition that the potential buyer pay me €1 today,
I have made:
– €1 (price of the premium, for
securing the stock price),
– and €4 (difference between
the current price of the stock and the price at which I will later sell it), if
the buyer decides to exercise the option.
I have earned €5.
If the buyer decides to not buy the stock,
I don’t make a profit, but I still have the income from the
premium – and I
still own the stock.
When I explain this, the overwhelming reaction is one of “But this sounds too good to be
true!”
And in a way it is!
Whatever
happens, you cannot lose money
But you might lose out – on a bigger profit.
This happened to me in 2009. I owned stocks in the emerging
market index and they were trading at €33 or €34. I sold a covered call
to sell them at €35.
And then the index went up way
past that. The person who bought the stock off me was very happy, as,
by spending the price of the premium, they were now able to buy the stock below market price.
And I lost out on the profit I could have made by selling the stock
at the higher market price.
But I had still made some
income, and a profit… Not too bad!
For the buyer, call
options are a means to potentially get a stock at a lower price than what the market is demanding, and
for the seller, they
are a means to guarantee they will earn money.
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