When you buy a call option you are essentially placing a bet that the share price of a particular company will be at or above a certain price by a certain date. That price is what is called the ‘strike price’ and that date is the ‘expiration date’. So what exactly are you paying for? A call option is a contract that grants the investor who owns it the right, but not the obligation, to buy 100 shares of the stock at the strike price if it reaches it on or before the expiration date. Call options are an investment strategy used when an investor feels that a stock is going to increase substantially in value over a certain period of time. That period of time can be as short as 1 day or as long as 2 years. The more time before expiration the more the option will cost since more time equals greater opportunity for the stock price to change in the investors favor. This is called ‘time value’.
What makes options so much riskier than purchasing shares of a company is you can lose all of your money if the stock does not reach and/or surpass the strike price by the expiration date. On the flip side, potential profit is infinite since a stock can increase infinitely in value. There are two ways in which you profit from a call option.
- Resell the option for a greater price than the premium you paid for it. This happens when the stock makes a big move up compared to it’s share price when you purchased the call.
- Exercise your right to buy shares of the company at the strike price and then resell them immediately on the open market. You make a profit when the market price is greater than the strike price which you paid such that you make more than the cost to buy the option.
Let’s discuss the terminology you’ll need to understand before buying call options and then look at an example.
Option value = intrinsic value + time value
- Option- A contract between the purchaser and seller of that gives the investor the right, but not the obligation (i.e. the option) to buy 100 shares of the stock at the strike price for every contract owned.
- At the money (ATM)- A call option is ‘at the money’ when the share price of the stock is equal to or greater than the strike price. In order for the call to be profitable at expiration the stock must trade for a price greater than the strike price such that your profit from reselling the option or exercising the option and selling the shares is greater than the premium paid to buy the option contracts.
- Out of the money (OTM)- When the share price of the stock is less than the strike price and the option has no intrinsic value.
- Time decay- Describes the progressive decrease in value of an option due to less and less time for the stock price to change as the expiration date approaches.
- Intrinsic value- The value of an option if it were to be exercised assuming it’s in the money. An options intrinsic value increases the farther above the strike price it is.
- Premium- The price/cost an investor pays to purchase an option. The farther out of the money and the less amount of time before expiration the less the premium is.
- Break-even point- The price at which you break even at the expiration date. This price is always above the strike price because you must be able to exercise and sell the shares for a profit equal to the premium paid.
- Writer- The person or institution that sells or ‘writes’ the option contract.
For our example let’s look at a scenario where we buy 5 option contracts of GALT at a $6 strike price expiring on October 19th.
5 call contracts at the $6 strike costs $50 dollars per contract (the price between the ask and bid you pay. Its not shown here but if you were to continue with the purchase it’s the price you’ll end up paying)
5*$50/ = $250 + commision fee ~$25= $300 dollars total investment
The breakeven price is approximately $6.50 at expiration and there is unlimited potential profit.