What Are Call Options?

The most basic example of a call option in real-life is that of ordering a pizza. You (the call holder) agree with the pizza delivery company (the call seller) to purchase a set amount of pizza at a predetermined price on or before a certain time [some pizza company's guarantee a delivery time].

It does not differ much in the stock market. In the pizza example, the pizza delivery company sold you the hypothetical call option for free. Typically, in the stock market this is not the case and the underlying asset is not a pizza, but a set amount of shares of stock (typically 100 per contract). Options have something called time-premiums, which is how much more the contract is worth based on how much the stock could move given the amount of time the call option has until expiration.

To modify our first example to better fit how it works in the market, you (the call holder/buyer) would pay the pizza delivery company a certain amount for the right, but not the obligation to buy a set amount of pizza, at a set price, on or before a certain time. Notice, the words "the right, but not the obligation" meaning you could change your mind and say you didn't want the pizza at anytime even when they came to your doorstep --- you would not be legally/financially obligated to buy the pizza.

Where I come from, the pizza-man would probably get upset if you said you were not going to pay. However, if the pizza-company entered in the agreement with you for say, $5, that you were only buying the right to buy a set amount of pizza on or before a certain time for an prearranged price say, $20 (the current market price) --- then there would be no reason for any hard-feelings since they entered into the contract with you knowing that you might not actually want the pizza. And there would be no way for you to get your $5 back since that was what you paid them for the contract that gave you the right to buy the pizza.

In the stock market, many people buy the right but not the obligation to buy a set amount of stock on or before a certain date. There are many reasons for doing this, first off, some traders don't like committing a lot of capital (money) into each trade so they'd rather purchase contracts that give them the right to buy stock at a certain price if they so choose. If the stock rises in value, typically, the option contract rises in value.

To relate this to our original pizza-example, suppose it's the Super Bowl and there are just not enough pizzas being made by the pizza companies, so they decide to raise their prices because they can sell the same amount at a higher price when the Super Bowl is playing. One reason to have purchased that call option from them, that is, the right but not the obligation to buy a set amount of pizza, at a set price, on or before a certain time for those five dollars --- would be if you anticipated the price of pizzas to increase because of the limited amount of pizza and the increase in demand for them. If you were only out for the quickest profit, and say that pizza you agreed to buy for $20 was now going for $100 due to the aforementioned reasons --- you could actually sell your contract that gives you the right to buy what's worth $100 for $20 to a friend who was going to buy the pizza at market price ($100) for much more than $5.

Think about it, if Bob was about to pay $100 for a pizza and you come along and tell him you have a contract with the pizza company that allows the holder of the contract to buy the same pizza for $20, what would he be willing to pay for that contract?

If he bought it from you for $10, then he would save $70.

($10 for the contract + $20 for the pizza) - ($100 he was going to pay for the pizza) = $70.

If he bought it from you for $20 dollars, then he would save $60.

($20 for the contract + $20 for the pizza) - ($100 he was going to pay for the pizza) = $60.

And so on and so forth. Presumably, if it was a highly liquid market for pizza and these contracts --- someone would be willing pay at least eighty dollars for the right to buy it at twenty dollars if the market price of pizza was one-hundred dollars. At this price the person buying the call from you would end up the same if he had just flat-out bought the pizza at the market price of one-hundred.

You might ask, why would someone pay $80 for the right to buy something at $20 dollars that has a market price of $100. Wouldn't it be easier to just buy the pizza for $100 dollars? Remember that at the very beginning of this example you actually paid $5 for the right but not the obligation to buy the pizza at $20 on or before a certain time. And look at how well you ended up. You hold that nice little contract that allows people to buy something at $20 that is worth $100. In the stock market, there is a large market for these contracts --- of course they aren't giving you the right to buy pizza but to buy a set amount of stock at a set price on or before a predetermined date.

Also, in the stock market, stocks can theoretically go to infinity --- so if people anticipated that the market price for a pizza would go well over $100 before the contract expires, then what would stop them from paying $20 for the right to buy it at $100 if they thought the market price for pizza would go to $1000. Then they know they could at least sell it for $900, making a 4,400% return on their investment.

Believe it or not, these types of returns on certain option contracts happen just about every week. Only, on call options you always run the risk of losing 100% of what you pay for a certain contract. The contract won't be worth anything when it expires if it is for the right to buy a certain stock for higher than the market price.

Who would buy the right to buy a stock at $100 for anything if the stock is currently trading at $90?

Now, if there is some time before the option expires then the time premium we mentioned earlier would give it value depending on how long before the contract expires because the stock has a greater chance of moving past $100 the longer the time left (in theory).

If you're left holding the bag and there is no-time before the contract expires, then you can expect to lose everything you paid for the contract if it gives you the right to buy the stock at a price higher than where the stock currently trades --- and there wouldn't be much point in using it yourself since you would have immediate paper losses for buying something for more than it's worth.

That only covers the very basics of call options, although I hope it was helpful. There are many hypothetically examples we can come up with, now that you understand conceptually how call options work --- I'd encourage you to actually pull up an options chain for a specific large-cap stock you like and follow the correlation of price movements between the call options and the underlying stock.

Read More About:

Related Articles: