Call Option explained like a house

Call Option explained like a house

Call option explained like a house.

Call options explanation ends up being confusing and filled with jargon. It is a very easy and powerful concept if understood correctly.
We are going to explain call options using the housing market and our view of whether property/house prices will increase or decrease. We will go on to explore the different outcomes and risks of a call option.

  1. Techcial explanation of Call Option, as per Investopedia
  2. Simplified explanation of Call options
  3. Making Simplified explanation relate to technical terms of Call options
  4. Difference between American Call option and European Call Option
  5. Call Options Profit Loss – European/American
  6. Benefits of Call Option – European/American
  7. Risks of Call Options – European/American
  8. Conclusion of Buying Calls

Technical definition of Call Option:

(We will simplify it right after this)

Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer profits when the underlying asset increases in price.Investopedia

House with money for call option

Simplifying the Call Option definition:

Your opinion about houses in a particular area is that prices will go up within 30 days. Current house price is 1,000. You think it will go to 1,200.

The owner of the house wants to sell the house at 1,100.

You talk to the house owner and agree that you will pay him 50 today and if by the end of 30 days price is above 1,100 you “may” buy the house for 1,100.

This agreement of a price and timeframe in which you may buy the house from the house owner is called a “Call Option”.

Convert terms used in the example to technical terms:

Example
Technical Term
Your opinion about houses in a particular area is that prices will go up..
Bullish on the stock/underlying.
…prices will go up within 30 days…
Days to Expiry (aka DTE)
Current house price is 1000
Underlying/Stock price today.
..you will pay him 50 today..
Premium
..you “may” buy the house for 1,100..
The “1,100” is called Strike Price. Commonly referred to as Strike.

Main difference between American options and European options is:

Using our example above:

If the agreement between you and the house owner allows you to buy the house at the agreed price(1,100) at any time during the 30 days, then it is called a American option.

If the agreement between you and the house owner allows you to buy the house at the agreed price(1,100) only at end of 30 day period, then it is called a European option.

Profit-Loss Situations of Buying Calls

Case 1: Price remains same at end of Month
House Price:
(Month End)
Premium Paid
We Buy Above:
Profit/Loss
1,000
50
1,100
-50

Price of house at the end of 30 days.

Amount you paid to house owner for the choice to buy house at 1,100 at the end of 30 days.

Price you can “choose” to buy the house at from the house owner.

The price is less than 1,100. You tell the house owner to keep the premium.

Premium paid = 50

This profit-loss will remain the same for all prices till 1,100.
Case 2: Price is 1,120 at end of Month
House Price:
(Month End)
Premium Paid
We Buy Above:
Profit/Loss
1,120
50
1,100
-50 + 20 = -30

Price of house at the end of 30 days.

Amount you paid to house owner for the choice to buy house at 1,100 at the end of 30 days.

Price you can “choose” to buy the house at from the house owner.

House owner keeps the premium.

Premium paid = 50

The price is above 1,100. You buy the house at 1,100 and sell it for 1,120.

Profit/Loss = Sell Price – Buy Price – Premium Paid:

1,120 – 1,100 – 50 = -30

Case 3: Price is 1,250 at end of Month
House Price:
(Month End)
Premium Paid
We Buy Above:
Profit/Loss
1,250
50
1,100
-50 + 150 = +100

Price of house at the end of 30 days.

Amount you paid to house owner for the choice to buy house at 1,100 at the end of 30 days.

Price you can “choose” to buy the house at from the house owner.

House owner keeps the premium.

Premium paid = 50

The price is above 1,100. You buy the house at 1,100 and sell it for 1,250.

Profit/Loss = Buy Price – Sell Price – Premium Paid:

1,250 – 1,100 – 50 = +100

As price goes above 1,150(The price we agreed to buy at + premium paid), our profit will increase.

Specific case for American Options

Case 1: Mid-way through the month price goes above agreed price.
House Price:
(Mid-way)
Premium Paid
We Buy Above:
Profit/Loss
1,200
50
1,100
+50

Price of house 15 days into the agreed 30 day period.

Amount you paid to house owner for the choice to buy house at 1,100 within 50 days

Price you can “choose” to buy the house at from the house owner.

The price is above 1,100 and there is news of a possible dividend(or other such). You ask for the shares to be delivered so that you get the dividend/other.

Sellable Price(Market price) – Purchase Price(agreed) – Premium Paid = 1,200 – 1,100 – 50 = +50

In American options the person who paid premium can ask for delivery or give delivery any time during the agreed time period.

Benefits of Buying Calls

Once that we understand the profit loss of call buying, let us understand the benefits:

Less risk from sudden drop in prices.

Stock(house in our example) prices can potentially drop a lot over a period of time. If you buy a call option on your opinion about the rise in price of a stock, your maximum loss is the premium you have paid i.e. 50 in our example. While if you had bought the stock(house) and the price falls to 900. You would be at a loss of 100.

Potential for bigger profits.

Price of a stock can potentially rise a lot over a month. Buying call options can enable you to buy/speculate on 10 units of a stock when you would only be able to buy 1 unit in conventional approach of buying stock. If you are right about the stock you can potentially make 10 times the profit you would have made with buying stock directly. Be aware leverage is a double-edged sword.

Risks of Buying Calls

Losing the premium only to see the stock price go up in a few days:
Timing is one of the biggest factors in options, if you bought a call but the price movement did not happen till expiry then your premium paid is a loss. It is possible to see the same stock go up the next day or near-term after taking the loss.
You can buy another call, but now the price movement needs to be enough to cover the loss from last call and the premium paid for this call.

Being right about the price movement but wrong about the premium:
Your view of the stock was right, the price moved above your strike price but not enough to a profit i.e.:
Stock Price is greater than Strike price but less than strike price + premium paid.

Lag between delivery of shares and ability to sell them – region specific
Once the call option expires(i.e. settlement date has passed), there is a chance that you will get delivery of the shares if the settlement price is above your strike price. This can be compulsory as per region, please check the contract specifications.
This delivery of shares can take a couple of days. If the share price drops between this time then there is a chance of loss.

Buying calls conclusion

Call option buying can lead to massive gains in the financial markets by using leverage however they require an ability to time an investment. The risk is loosing your premium paid.

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All information here is for educational/research purposes only, we do not recommend trading.

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