Following up on the epic saga that was “what is an option” I present something more narrowly focused with put options forming the next article’s topic. The prior article mentioned what a call option is in pretty specific detail, but I thought I would go over it in a vacuum for the sake of sanity. This article assumes that you have read and understood the prior article explaining options. I have written this one in a less simplistic way and without the extensive explanations of all the little details that was in the prior article.
A call option allows the holder of the option to purchase an amount of shares (100 per contract) for a specified price (strike price). This right is valid for a specific period of time, the end of which is termed the expiration date. This right is usually exercised automatically if the option is in the money.
Call Option Walk-through
Let us walk-through a call option from the beginning to end. Imagine you want calls of stock Y at $10 for a price of $0.20. These are standard options meaning that it stands for 100 shares. The price of an option is quoted at the price per share. Therefore for each contract you have to multiply the number by 100. So the cost per option is $20. You grab 5 of them for a total of $100 plus commissions. The expiry is for next month, which gives you about 4 weeks of time. Y is currently at $8.
Now you hope that the price of Y increases to $10 and above as fast as possible. This would make your call worth quite a bit more, and if you wanted to own the stock you would get it cheaper than market. Continuing the walk-through assume that Y went to $11 in 1 week after you bought the option.
The value of the option would be at least $1 plus whatever time value is left. This varies based on many different factors, and I will discuss option premium at another time. In short though the price of an option is equal to its intrinsic value plus extrinsic value. Extrinsic value is referred to as the premium. Intrinsic value is the amount that the option is worth at expiry. For out of the money options this is 0. For in the money options it would be the gain the position would have at its initiation.
In the case of our option it would be $1 since the market value of Y is $11 and you got it at $11. You could turn around and sell it for $11, theoretically. I say theoretically because for automatic assignment of the option the market would be closed. You would be able to sell the next time the market was open, and the price might change.
Now back to our walk-through. It is 1 week after you bought your option and the value of the stock has increased to $11 from $8. At this point you can sell the call and take your gains. Or you can wait till expiry and if the price is still above $10 the option will be exercised and you will purchase 500 shares at $10 for a total of $5000. If the price of Y is $11 then your position will be worth $5500, although you do need to turn over $5000 to obtain the shares. If you have the account balance then you can hold into expiry otherwise you should definitely sell.
I want to go over again what constitutes in-the-money (ITM) for a call option again. It is touched on above, but it warrants revisiting. In the case above ITM for Y would be anything above $10. The strike of our option determines the line that needs be crossed for ITM. If it was a strike of $15 then that would be the line to cross to move from out-of-the-money (OTM) to in-the-money. Remember while the option is valid there is a term of convenience called at-the-money (ATM), which just means the options right around the current price. $9.98 and $10.02 might be considered at-the-money, though one is technically OTM and the other is ITM.
Remember the Counter Party
It takes two to option. As the holder you have the right to receive the shares at the strike price. The counter party is determined automatically. There is not a name written on your option. In the world of electronic trading, not to be confused with high frequency trading, you don’t even get a paper to signify your option. The matching of parties is handled by the options clearinghouse and happens without your intervention.
The counter party has to deliver the shares. They wrote the option contract, which is basically making an offer to deliver the shares at the option of another. A contract is an agreement between parties. In what is an option article, I discussed how the contract works. Let me go over it again in more legal terms. I went to law school so I will tend to describe it in those terms.
Party A makes an offer to give another the right to buy shares of a stock at a certain price. The right is the offer, but since it is a right it does not have to happen. That is why it is called an option. It is also why I did not say that A would sell the shares at a certain price. The transaction may or may not happen.
Party B accepts party A’s offer and delivers a cash payment to party A. Party B now has the right to buy the shares from A whenever party B chooses. These are American-style options that can be exercised at any time before expiry. In practice this right will only be exercised at expiry when the option is in-the-money and will be automatic. I have never heard of someone exercising their options early.
I do not want to go over the reasons to buy call options again. I discussed it in an earlier article. It can preserve the bullish case. It can also hedge your position if you are short the stock. The focus has been on buying options. In a later article I will discuss writing options. The follow-up to this article will be about puts, and will probably dedicate an article to examples of different options positions. This article went on a bit and covered ground already discussed before. I did not make it as simple as the prior article, but I think you can still follow it if you understood the previous article.