Stock Option Basics—The Call Option
We hear about Silicon Valley executives who pocket millions when they leave their companies or Wall Street traders who make a killing when the stock market moves a few points. What alchemy creates such unbelievable returns? The answer: stock options. Stock options are essentially contracts to buy or sell shares of stock at a certain price, within a certain amount of time. Options to buy stock are known as call options and options to sell stock are known as put options. In this article, we’ll review the basics of the call option which allows an investor, trader or even the fortunate executive in a company to profit from the upward movement in a company’s stock price.
Suppose you are interested in investing in Bailout Industries. Their stock is currently trading at $10 per share and you believe it could go as high as $15 per share in the next year. In order to buy 100 shares of Bailout stock, you’ll need to shell out $1,000. If the stock were to reach $15, you could sell the stock for $1,500 and pocket a cool $500 profit. Now, consider what can be achieved if you buy the call options. The December 2010 $10 call option is currently selling for $1. In other words, a contract to buy one share of stock at $10 before December of 2010 is priced at $1. With $1,000, you could buy 1,000 call options. So what happens if you buy the call options and the stock does reach $15 next December? Your position is now worth $5,000! Not bad for a $1,000 investment. Sound too good to be true? Well, it can be.
The problem with call options is that they are simply contracts. When the terms of the contract are not met, they are essentially worthless. If Bailout stock falls below $10 and remains there at the time of expiration, the options are worthless and you’ve lost your $1,000. In future articles, we will take a look at put options and option valuation.