What Are Call Options?
An option can be defined as a contract between two people, giving one the right, but not the obligation to buy (call) or sell (put) an asset at an agreed upon price during a specific time.
As shown in the words in parentheses, there are two main types of options: calls and puts. Call options give the option to buy at a certain price, so the buyer would want the asset’s value to go up. Put options give the option to sell at a certain price, so the buyer would want the asset’s value to go down. This article will focus on explaining calls. The next article will delve into puts.
Call Option Scenario
An easy to understand example is if an option buyer, Bob, wants to buy a house, but doesn’t have the money for it at the moment. Bob may buy an option on the house by paying the seller $1,000 for the right to buy the house for $100,000 within the next six months.
If Bob doesn’t buy the house in six months, the option expires and he loses the $1,000.
If he exercises his right to buy the house, the seller keeps the $1,000 and provides Bob the house for $100,000 , even if the house is now valued at $200,000. In this case, Bob paid $1,000 but has made $100,000 in equity in the house.
However, if the housing market drops and the home is only worth $75,000 in six months, Bob does not exercise his right to buy the house. The seller keeps the $1,000, but Bob doesn’t lose the $25,000 decrease in the home’s value.
Another alternative is to resell the option to another person, as is what happens in stocks. For this example, Bob could sell the option that he paid $1,000 to someone else, say Alice, for $25,500 because she believes the price of the house is going to go up to $200,000 in the next few months. Alice now has the right, but not the obligation to buy the house for $100,000.
Relating the Example to Trading
Remember, a call option is having the right to call it away from them. The strike price Bob has the right to buy at is $100,000. The expiration date is six months from today. The premium Bob paid is $1,000.
Premium is made up of two things: Intrinsic Value and Extrinsic Value. When the house was worth $100,000 and Bob bought the right to buy it at $100,000, the $1,000 he paid was extrinsic. It was only buying time, but had no real value.
When Bob sold the option to Alice for $25,500 because the house increased in value to $125,000 in three months’ time, Bob received $25,000 in intrinsic value (real value) and $500 in extrinsic value (time value).
This is the basics of call options. There is an agreement made between two parties giving one the right, but not the obligation to buy an asset at an agreed upon amount. In the next article, the important basic points of put options will be discussed.
© 2016 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.