Worked Example Of Buying Call Options

What is a call option?

A call option is a contract that conveys to the buyer of it,  the right to buy 100 shares of the underlying security at a specific price( the exercise price or strike price) on or before a specific date. The buyer of the call option has the right but not the obligation to buy the underlying security. Call option buyers must take note of the preceding statement. The call option buyer is also known as the holder of the option contract.

What is a call option

Since a call option is a contract, the rights of the call option seller are opposing to those of the rights of the call option buyer.

The call option seller is also known as the writer of the call option. The writer of an option contract collects a premium from the call option buyer, facilitated by the exchanges, and hence has the obligation to sell 100 shares of the underlying security at a specific price( the exercise price) to the option buyer when the option is exercised by the buyer.

Each stock/equity option contract is representative of 100 shares of an underlying security.

Call option buyer Has the right but not the obligation to buy the  underlying security
Call option seller Has the obligation to sell the underlying security to call option buyer

A call option buyer has a potentially infinite profit potential while the maximum risk is the loss of the premium paid for the call option. A call option seller has potential profit that is limited to the premium collected. However, the call option seller has a maximum risk of an infinite loss, in other words, a risk of an unlimited loss. All this is reflected in the diagram above.

Potential profit and loss of a call buyer

Call option chart

According to the table here, the maximum profit of the call buyer is unlimited while the loss is limited to the premium.

Relationship of price of underlying security to call option premium

Price of Underlying Security

In general, when the price of the underlying security increases, the call option premium will increase. Also, if the price of the underlying security decreases, the option premium will decrease.

 Buyers of call options are bullish on underlying security

Buyers of call options want the price of the underlying security to rise significantly. As the price of the underlying security rises, the option premium increases. The buyer of the call option can proceed to sell the call option at a higher price than he paid for it, thereby, earning a profit.

When to buy a call option?

Call option buyers predict

A trader would buy a call option when he is bullish about a certain company.

Let’s examine a certain example.

Apple Inc is company that we have all heard of. It’s earnings forecast is good and it has given analysts good guidance. You look at the charts and figure out that it is going to go higher from now on within the coming weeks. .Apple’s price is $115 currently in the market. You decide that you should buy a November 2015 call options with an exercise or strike price of $115. You proceed to buy 1 option contract which cost you $2 per option contract. As you know each option contract has an underlying security of 100 shares.

$2 x 100 = $200

Hence, you pay a total of $200 which is the option premium that you pay for the call option.

True enough, the stock price of Apple Inc rises to $121 and the call options contract that you possess is now priced at $6.50. The call option is now in the money as the Apple’s stock price has gone beyond and above the exercise price of $115.

Sell the option before expiration

You sell the option before expiration date at $650. How did we arrive at that figure?

$6.50 x 100 = $650

Ignoring bid-ask spreads  that market makers or commissions that brokers earn, if you sell the options contract at $6.50 and since each option contract has 100 shares of the Apple stock, you have essentially sold the contract at $650.

Your profit can be calculated as follows :

$650 – $200 = $450

Your return on investment can be calculated as follows:

450/200x 100% = 225%

If you had bought the stock instead, your return on investment would have been lower. Let’s say you bought a 100 shares at $115 per share. This is what you will have to pay without taking brokerage commissions into account: 

$115 x 100 = $11500

After the price increase, you proceed to sell the shares at $121 per share. Your proceeds would be calculated as: 

$121 x 100 = $12100

Your profit would be calculated as follows:

$12100 – $11500 = $600

Your return on investment can be calculated as follows:

$600/$11500 x 100% = 5.22% ( corrected to 2 decimal places)

Imagine for a moment now if you have understood me so far.

If you use options, you stand to make a return on investment of 225%. But if you opt to buy equity(stocks) of Apple instead, you have only made a paltry 5.22% .This is really the power of leverage at work.

This is also called the Long Call Option strategy where a trader buys in expectation that the option premium increases alongside with the underlying security price within a specified time frame. The trader is making a calculated bet that the underlying security price will increase beyond the exercise price of the option contract purchased.

Call option chart
Read:
Long Call : Profit From Rise In Price Of Underlying security

Comparisons of long call vs long stock

Execute A Synthetic long call : Bullish strategy