A call option allows the investor to purchase assets at a previously stipulated price for a limited period of time. For this convenience, you must pay an option premium. If you don’t purchase stock within this timeframe, the option expires and you can no longer purchase the asset for the specified price. Depending on how the asset’s price changed during that time period, you may lose just the option premium or the gains you would have made from the stock.
Options are a type of derivative contract that gives the buyer the right to buy or sell at a certain price. The key here is the word “right.” They have the option, or the right, to buy a stock at a certain price but are by no means obligated to do so.
Stock options effectively give an investor the opportunity to bet on the future movement of a stock or asset price without being 100% obliged to invest in it. The two elements that are always present in a stock option contract are an agreed-upon price, or strike price, and an agreed-upon date, or expiration date. The idea behind options is to diversify and hedge risk while taking advantage of upswings and downswings in the market.
The two most common types of options are call and put options. When you buy a call option, you pay for a contract that gives you the right to purchase a stock or asset (called the underlying security) at an agreed-upon price until the option expires. With put options, you pay for a contract that gives you the right to sell a stock or asset at an agreed-upon price before the expiration date. After that period of time, the options expire.
Options and strike price
The most important aspect of an option is that it gives you the right to wait and see. When you buy a traditional stock or asset, you pay for it upfront. You send your money to the broker, and in return, you receive ownership of the stock or asset.
With an option, you pay for the right to purchase or sell later at the strike price or sell the option at its intrinsic value. The agreed-upon price that you exercise with an option is called the option’s strike price. Once your option hits this strike price, you can exercise it.
This is important in the world of investing as it allows you to hedge risk and not employ your capital upfront. To understand how this is important, let’s take a look at option scenarios and examples.
A call option is a derivative contract that allows an investor to buy an asset at an agreed-upon price within an agreed-upon time frame. They purchase this option with the hope that the stock will increase.
The strike price will be the agreed-upon price that they will purchase the option. The strike price on a call option will hopefully be much lower than what the market value is when the stock increases.
Call option example
Let’s say that you feel that wheat is going to be a commodity that you feel will be undersupplied in the near future. That being said, you don’t want to put all of your money into stocks and commodities related to wheat upfront.
Based on this assumption, you decide to invest in Wheat of the World, Inc. (WOW), which is currently listed on the S&P for $20 per share. You feel that this stock could easily double in six months. If you want to make a bet on WOW but want to hedge, you would get a call option contract and pay an “option premium” to have the right to buy WOW Inc. stock. The call option to buy gives you a strike price of $20 over three month period.
WOW list price = $20
WOW call option strike price = $20
WOW call option expiration date = 3 months
WOW option premium = $2
You buy five call options of WOW for $1,000 in total. Now let’s say that the price does indeed double to $40 per share in two months. Because your call option contract’s timeframe is for three months, you can buy it for the $20 agreed-upon stock price, plus the options premium. The ROI breakdown works as below:
WOW new list price = $40
WOW call option strike price = $20
WOW option premium = $2
If you were to pay directly for WOW at the time you purchased your options, you would have doubled your investment with a return of 100%. However, that position would have cost $10,000 (500 shares x $20 per share). Instead, by taking out a call option, you are still able to make a decent ROI while only risking $1,000. If, on the flip side, WOW were to decline by 20%, you would only be on the hook for the option premium that you paid and would not lose the entire 20%.
If you prefer this style of investing, you may want to consider opening an account with one of the brokerages below, all of which deal in options.
Why do options have a time frame?
Options are only available for a specific time frame. This has to do with risk calculations being formed by both parties. If an options writer sells you a call option contract for an unlimited period of time, this can run a great risk.
Let’s say that your purchase of WOW stock didn’t have a period of time or a much longer period of time. The stock might increase by 500% in 10 years.
If you exercised the option ten years from now, then the option’s writer would be loathed to take a 500% loss on their books by selling you the stocks for way below market value based on your options contract. Just as you analyze risk for investing, so do the options writers providing options contracts.
What happens when a call option expires?
When an option contract expires, there are three definitive possibilities. They can expire in the money, out of the money, and expire worthless.
In the money
If your call option has a strike price that is below what the current market price is, you are “in the money.” This means that you stand to make a profit based on the difference between the current market price and the strike price that was listed on your option. You need to make sure you exercise the option so that you are able to obtain your profits before it expires.
If the call option expires and you are “in the money,” you lose two things:
- The premium that you paid for the option; and
- The lost profit you would have made on the difference between the strike price and the list market price.
In the WOW option, you are losing both the $2 premium you paid, as well as the opportunity to make a profit from the difference between the strike price and market price. In this case, $20 (40 – 20 = 20).
Out of the money
Though you still lose some funds when a call option expires “out of the money,” this amount is smaller compared to what you would lose should your option expire in the money. If your option expires and you are out of the money, then the only money you would have lost would have been the premium.
For example, in the WOW scenario, you would lose the $2 premium you pay per share. When a call option expires and it’s out of the money, this is called, “expire worthless.”
“Expire worthless” is a term used to define call options that exceed their expiration date. If an option expires worthless, there is no profit to be made on the option. The buyer loses the premium paid, and the option is now worthless.
Trading options and timing
Options behave similar to the actual underlying stocks, as you can trade the contracts, just like you can stocks. Options contracts will increase or decrease in value on the trading market due to the state of the market as well as the time of the expiration date.
For instance, if the wheat market is booming, and you have a three-month option to purchase WOW stock, you will most likely get more money for it if you sell it after two months than waiting for the last day of the final month to see if the price continues to rise. This is because the buyer of your options wants as much time before the expiration date to exercise them as possible.
Options’ role in the 2008 financial crises
The ability to exercise financial options is directly tied to the ability of the option’s writer to buy or sell the options and pay out money. Typically, these options writers will take on the insurance that underwrites the contracts on an even deeper level. If the market suffers from a systemic shock, such as what happened in 2008, this whole structure can be in deep trouble and thus require government intervention. This is because both the options writers and the insurance companies that underwrite insurance on options are in trouble.
This is why AIG had to be bailed out during the financial crisis. AIG was known to most in the US as an insurance company that would insure things like family or home insurance. What most people didn’t know was that AIG insured the options that were related to betting on various parts of the housing market. When the system crumbled, AIG was forced to take an $85 billion loan from the federal government in order to ensure its solvency.
What happens if I don’t sell my call option on expiry?
If you don’t sell your call option on expiry, then you no longer have the right to buy the stock for above or below the current market price. You also lose the premium paid for the asset.
Do I owe money if my call option expires?
No, you do not. You will lose the premium you paid when you bought the option, but that is it.
How much do I lose if my call option expires?
It depends on how you define “lose.” You will lose your premium paid. But there may also be an opportunity cost if your call option was in the money when it expired.
In that case, you lose one of two things: the gain in intrinsic value on the option contract, or the gain on the asset if the option was exercised.
- Options are the right to buy or sell at an agreed-upon strike price for a specific period of time.
- Call options give the investor the option to buy at a strike price, and put options give the investor the right to sell at a strike price.
- Options require an option premium. However, an option premium gives the buyer the right to buy the underlying security and requires the seller to sell the underlying security.
- The expiration date on an option is the time period in which the option must be exercised.
- Options can be risky, but when used appropriately, can hedge risk and diversify a portfolio.
View Article Sources
- Options Trading — U.S. Securities and Exchange Commission
- Options — Investor.gov
- How to Avoid Capital Gains Tax on Stocks — SuperMoney
- SuperMoney Investment Guide — SuperMoney
- How to Invest in the Stock Market: 8 Basic Concepts — SuperMoney
- How to Buy Stocks with a Debit Card — SuperMoney
- Can You Buy Stocks With a Credit Card? — SuperMoney
- Contango vs. Backwardation: What is the Difference? — SuperMoney
- Can F1 Students Invest In Stocks? — SuperMoney