What is a Call Option?
By Max Grinold
Call options are a unique trading strategy where investors have the option to buy shares of a stock at a pre-determined price (the strike price). If an investor owns a call option, they must buy the shares before an agreed-upon date (expiration date), and the price of the stock must hit the strike price, otherwise the option cannot be exercised. To get a better understanding of call options, let’s run through an example with a pair of basketball shoes:
Let’s say that there is a pair of basketball shoes that I believe will become very popular and increase in price soon. I’ve seen these shoes all over social media, and some of my favorite celebrities are wearing them, so I believe there’s going to be a large increase in demand for them in the coming months.
Knowing this, I go to the shoe store and make a deal. The shoes cost $100 right now, so I ask the store manager if I can pay him $10 for the right to purchase the shoes at $120 one month from now. The store manager agrees and I continue on with my day, planning to revisit the store for my purchase next month.
During the month, the basketball shoes are becoming red hot! Everybody wants their hand on a pair, and every scroll through social media has a different celebrity wearing them. Since the demand for the sneakers has skyrocketed, the market price has risen to a whopping $200!
Once the month has passed, I go right back to the shoe store and cash in on my agreement to buy the sneakers for $120. I then go right to the marketplace and re-sell these new sneakers for their new $200 price tag, making $70 in profit including my fee with the store manager.
What if the price of the shoes didn’t increase throughout the month? Let’s say my belief was incorrect, the shoes never became popular, and they stayed at the same price. Since the value of the shoes never surpassed my agreed-upon strike price of $115, I can’t cash in my agreement with the store manager. My agreement with the store manager was contingent on the fact that the market value of the shoe would surpass $115. So since the value didn't surpass that $115, my purchasing agreement no longer stands, and I unfortunately wasted the $10 I spent last month.
It is important to note the risk in this scenario. If the shoe price doesn’t rise above the agreed upon value, I’m not able to exercise my option with the store manager. However, there is also a bit of downside protection in this scenario as well. Let’s say I purchased the shoe outright at the beginning of the month, and the price actually dropped to $80! With this strategy not only do I have to pay $100 upfront, but now I may have to sell the shoes for less than I bought them for. This is where some investors use call options, to put less money upfront. However, if the call option doesn’t hit above the strike price, they still must pay the premium for purchasing the option regardless of their inability to convert it into shares. This strategy is used only with very experienced, professional investors, and isn’t often a strategy used by common long-term investors. While call options can be a method of limiting upfront costs and managing risk, they also require a deep understanding of market movements and timing.
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