Options trading allows an investor to take part in an equity investment that trades at a significantly higher share price than the premium of the underlying stock. For example, Alphabet, Inc. GOOG 779.91 0.00 0.00% is trading at $697.46 per share as of June 22, 2016. To purchase a round lot of 100 shares, an investor would need to have $69,746.00 in cash to purchase the shares. However, an options trader can purchase an options contract at a significantly lower price. Alphabet, Inc.’s current options chain for call options, which are out-of-the-money, is trading with an ask of $7.70, which is $770.00 for the round lot. This is the call option for an expiration date of June 24, 2016. This options contract is roughly the same price as one share of Alphabet, Inc.
Call Option Contracts
When an investor purchases a call option, that investor has bought the right to purchase a stock for a specific price at a specific time. The specified price is known as the strike price (or exercise price). As the underlying security moves above and below the strike price, the call option contract falls either in-the-money or out-of-the-money.
Call Option Example
The June 24, 2016, call option has a strike price of $697.50. Technically, this option is out-of-the-money by $0.04 (Current Share Price of Alphabet, Inc.: $697.46 – Strike Price [June 24, 2016, Call Option]: $697.50). If Alphabet, Inc.’s share price moves above the strike price, the premium of the call option will increase dramatically. The ask for the call option with a strike price of $687.50 (June 24, 2016) is trading at $13.10, or $5.40 higher than the June 24, 2016, call option with the strike price of $697.50.
This example shows how an options trader can participate in the rise of a stock price for a relatively small investment as compared to the share price of the underlying security. Options traders do not need large cash reserves to make an investment and earn a significant profit. However, there is a catch: the underlying security must be in-the-money before the expiration date in order for the call buyer to earn a profit. If the underlying stock never moves above the call option strike price, the call option might be worthless or sold for a significant loss.
Call Option Advantages
One advantage the options trader has over an investor who owns the underlying security is that the most an options trader can lose is the price they paid for the options contract. An options trader who has purchased the June 24, 2016, call option with a strike price of $697.50 would at most lose $770.00. If Alphabet, Inc.’s stock price is cut in half, an investor who owns 100 shares would lose half their investment of $69,746.00, or $34,873.00.
Call Options: In-The-Money
A call option that is in-the-money does not have to be exercised, but if the options trader would like to exercise the option, they can do so and purchase the underlying security at the strike price in the options contract. The call option seller would then be obligated to sell the underlying security to the option buyer at the strike price. Not all option buyers exercise the option; they may choose to sell the in-the-money option for a profit to another options trader.
Call Option: Seller
A call option seller may write an options contract for a number of reasons. One reason may be that the call option seller does not believe the share price will reach the strike price. In this example, a call option seller can write a contract and earn a profit from the call option buyer while still maintaining ownership of the stock. If the option reaches the expiration date of the contract and the underlying security price never reaches the strike price, the call option writer profits the amount of the premium paid by the call option buyer. Essentially, the call option seller caps their profit by agreeing to sell the underlying security at the strike price if the share price moves above the strike price.