Call Options on Stock

Stock options allow investors to participate in the market as owners of common stock. An option allows the owner to control a certain number of shares of common stock- without having to pay for all of the shares to gain the control. A derivative is often defined as a financial instrument that is based on the value of another security. So, an option can be considered a derivative. The value of the option moves with the market price of the underlying common stock.

An example

Assume you’re interested in buying IBM common stock. You’re interested, because you believe the stock price will go up. If you buy IBM at the current price of $40 per share, you hope to sell it a gain after the price increases.

Controlling 100 shares of stock

There are two ways to control IBM common stock (more than two, but that’s a discussion for another day!):

1.     Buy 100 shares of common stock. Pay (100 shares * $40) = $4,000 (Ignoring commissions).

2.     Buy 1 call option at a strike (exercise) price of $40 per share. The buyer pays a premium of $2, or $200 total. 

An option is a contract

1 call option allows the call buyer to control 100 shares of common stock. A stock option is a contract. The buyer has rights and the seller has an obligation.

1.     The call buyer has the right to buy 100 shares of IBM at the strike (exercise) price of $40 per share. Buying the stock is referred to as exercising the option. The buyer can exercise the option on any business day until the option reaches expiration (usually 3 months). The buyer pays the premium of $2. Since $2 controls 100 shares, the total premium cost is ($2 * 100 shares) = $200.

2.     The call seller receives the $200 premium. The seller must sell the 100 shares of IBM stock to the call buyer at $40 whenever the call buyer chooses to. That’s the call seller’s obligation. If the call seller does not own the IBM share when the call buyer exercises, the call seller may need to go into the open market can buy them to make delivery of the shares.

Your choices as an option buyer

The call option buyer has three choices:

·            Exercise the option and buy the 100 shares at $40.

·            Let the options expire worthless. In this case, the buyer simply gives up the premium that was paid.

·            Sell the option to someone else. Since stock options are considered securities they have a market (buy and sell prices). The call buyer may find another buyer who is willing to buy their option. They might sell the option for a gain or loss. The option price will change, along with the underlying security’s price.

      

      This video should help explain the concept:

http://www.youtube.com/watch?v=awu6L-epxDk

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Ken Boyd

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