Lying at the core of any successful options trader’s foundation is a basic understanding of call options and put options. These two vehicles are the fundamental building blocks upon which all option strategies rest. Today, we turn our focus to the first of these two essential tools – the call option.
A call option is a contract that gives an investor the right, but not the obligation, to buy shares of stock (usually in units of 100) at a specific price (the strike price) on or before the expiration date.
While the definition may seem a bit clunky, you’ve probably used something very similar to a call option many times in the past – a pizza coupon. A pizza coupon gives you the right, but not the obligation, to buy a pizza at a specific price on or before the expiration date. The value of the pizza coupon is tied directly to the price of a pizza.
Suppose you own a coupon that locks in the right to buy a large cheese pizza for $10 at any time over the next three months. With the price of a large cheese pizza sitting at $15, your coupon is currently providing a $5 discount. Now, let’s say the price of cheese pizza rises to $20 over the next month. What would happen to the value of your coupon?
It would rise as it now locks in the right to buy pizza at an even greater discount.
If, instead, the price of cheese pizza fell to $10 over the next month, your coupon would undoubtedly fall in value as well.
Call options operate in a similar manner. They lock in the right to buy a stock at a specific price and will therefore see their value fluctuate as the underlying stock rises and falls. Buying call options, then, presents a cheaper, more leveraged way to bet that a stock will rise in value.
While the underlying stock’s price is a key driver of an option’s value, two other variables influence the price you will pay for an option – time and volatility.
To understand the value of time, let’s turn back to our pizza coupon analogy. Suppose you have a coupon locking in the right to buy a cheese pizza at $10 that expires tomorrow. I have a coupon locking in the right to buy a cheese pizza at $10 that expires in one year. Whose coupon do you think is worth more?
Mine, of course. The reasoning is simple. Pizza has more of a chance of rising in value over a year than one day. The same rationale applies to call options. Long-term options are more expensive than short-term options.
Now, what of volatility?
The reason volatility matters is that it can have a huge impact on how much the option is worth at expiration. A stock that is expected to be really volatile in the future will have more expensive options. A stock that isn’t expected to move much will have cheaper options.
Let’s end with an illustration. Suppose you are bullish on Exxon Mobil (XOM), currently trading at $101. Instead of buying 100 shares, which requires a hefty $10,100, we could purchase a three-month 100-strike call option for a mere $220. This option locks in our right to buy 100 shares at $100 and should rise in value as XOM stock rises in value. The maximum risk – as with any option purchase – is limited to the initial cost, which, in this case, is $220. $220 of risk is drastically less than the $10,100 of risk you would have acquired had you bought the stock.
The maximum reward is unlimited, so you will continue to rack up additional profits, no matter how high XOM goes by expiration, three months away.
- Jonas Taylor is a financial expert and experienced writer with a focus on finance news, accounting software, and related topics. He has a talent for explaining complex financial concepts in an accessible way and has published high-quality content in various publications. He is dedicated to delivering valuable information to readers, staying up-to-date with financial news and trends, and sharing his expertise with others.