How does a Call Option work?
Call Option Example:
John has a house next to a vacant land which he is trying to sell for $700,000
There are 2 people interested in buying the vacant land.
Investor 1: Frank wants to buy it and put in a community park this will increase the value of surrounding homes including Johns home.
Investor 2: Bob wants to buy it and put in a strip mall – this will decrease the value of the surrounding homes including Johns home.
John has 1 interested buyer named Lucy – She is interested in buying Johns house for a cash deal but Lucy doesn’t have the cash at the moment and is waiting on a different deal to close – but she is afraid the house is going to sell. So Lucy (buyer of the call option) offers John $7,000 dollars to take the house off the market (option premium).
John says Ill give you the option to buy my house (Call Option) for $700,000 any time during the next 3 months ( expiration date).
These are the 2 different scenarios that could play out for Lucy
1. Lucy decides not to buy the house – John keeps the $7,000 dollars (option premium) and can put the house back on the market.
2. Lucy decides to buy the house – John keeps the $7,000 dollars and Lucy buys the house for $700,000
These are the 3 different scenarios that could play out for the price of the house in the 3 months.
- Investor 1 Frank buys the vacant property and puts in the park which increases the value of Johns house to say $800,000 –
- In this case Lucy would be even happier to buy the house for $700,000 which she has locked in with the $7000 premium (or option premium) and have the house with an increased value of $100,000.
- Investor 2 Bob buys the land and starts the development of the strip mall which decreases the value of Johns house to say $600,000 –
- In this case Lucy would be sad and walk away from the deal and lose the $7,000 option premium (but would not lose the property value of $100,000
- Neither investor buys the property next door to Johns house and the value of the house remains the same and Lucy can decide to either buy the house for $700,000 or not – but Lucy was able to control the $700,000 property for 3 months for $7,000 – so Lucy’s risk was only the $7,000 and not the potential change in value of the property
Side note in the story – had there been other interested buyers in Johns house he could have increased the option premium to something higher like $14,000
Definition of Call Option as it relates to stocks:
A call options is a contract between two different people or parties to exchange a stock at a price which is called the strike price and this is done by a predetermined date. Call option in the story above was $7,000 and the predetermined date was 3 months.
One of the parties is the buyer of the call option and this person has the right but not the obligation to buy the stock at the strike price by the future date. The other party is the seller of the call option and has the obligation to sell the stock to the buyer at the predetermined price or the strike price if the buyer decides to exercise its option – in the example above Lucy was the buyer and had the right for 3months to buy the house at $700,000. John was the other part the seller of the option and had the obligation to sell the house within the 3 months if Lucy decided to buy at the set price of $700,000 no matter if the value went up or down.
Now an example with a Stock
If a certain stock is trading at $100 dollars a share and it was in an up trend and you thought the price of the stock was going to continue higher to say $150 – you could buy a $125 call option for say .50 cents. You would be the call option buyer in this example
If the stock continued to move up as expected and hit $150 that would allow you to buy the stock at $125 and net the $24.50 per share ($25 minus .50 cents )
If the stock stayed at the same price the call would expire worthless and the call buyer would be out only the .50 cents. The call seller in this instance would keep the .50 cents.