Option Basics Part 1: Buying a Call Option
And How Call Options are like Sports Betting
Stock Options (calls & puts) have a mystique around them. You may hear them and think of the horror stories of fortunes lost. Or you may view them as a way to de-risk and hedge in your portfolio. A lot of people think they are entirely too risky and complicated and avoid them completely.
It probably doesn’t help that academia has made them practically impossible to understand. And even if you learn it, the formulas tend to be most useful in a financial model for projections and impractical to use as a small everyday investor.
Honestly, options don’t need to be so complicated and can be a huge benefit to a portfolio when used correctly.
I will unpack all you need to know to start investing in options, without requiring you to even process 1 wiener…unless your into that, I mean if its your thing god speed.
Options & Sports Betting - An Analogy
A lot of my friends are heavy into sports betting. They understand all the mechanics of the spreads, betting across numerous games, and prop bets. Many people have a better understanding of betting on an NFL game than investing in stock options. However, the 2 are fairly analogous and I find it helps.
When you bet on an NFL game, there is a ‘spread’ that is supposed to balance the odds between unequal opponents. Take Green Bay (13 wins) vs Detroit (3 wins) and you would assume Detroit would get points in the game since they are the weaker team. For simplicity, Detroit gets 10 points, meaning GB needs to win by 11+ in order for your to win if you bet on GB. When you place your bet, you are given a set payout for if you win.
You are basically entering a call option with a fixed payout. If you choose GB to win, you are buying a “10-point out-of-the-money” call option at the start of the game.
If you can understand how the bet goes, you can understand a call option.
What Is A Call Option?
Buying a call option is betting the stock price goes up. This is also known as taking a ‘long’ position.
A more detailed definition is “when you BUY a call option you are purchasing the right, but not the obligation, to receive the underlying stock at a given price (the strike price) and at a given date (maturity date)”. It is a wordy definition. In short, you pay a little money today and have the option to buy the stock in the future at a set price.
If you buy a call, and the price of the underlying stock is above the execution price in the contract on the maturity date, you win. It is easy to follow with an example.
[Side Note: The reason calls and puts are called derivatives is because their value is derived from the value of something else, in this case an underlying stock price]
Call Option Example:
Below is a simple example to help you visualize what happens when you buy a call option. We are looking at a stock that is currently priced at $4.50 a share on Jan 15. You purchase a call that expires in 1 month with a $5 strike price. The cost of the option is $0.25. There are 5 scenarios shown with different prices of the stock on the maturity date and your resulting profit.
First, note that the price is listed as $0.25, but in the 3rd column the option cost is $25. Why is this?
All options are based on 100 shares of the underlying stock. Additionally the payout and profits on 2/15 also reflect the 100 share position. It is important to remember this because most brokers will display the option prices based on only 1 share (the $0.25 price) but you have to trade it in 100 share lots.
Looking the ‘low’ $3 stock price scenario you can see that:
You purchased a call option hoping the stock went up from $4.50 to over $5. However, the price went down to $3.
The call option gives you the ‘right but not the obligation’ to purchase the stock at the $5 strike. You would not execute the option and pay $5 for a stock that is currently trading at $3.
The option expires worthless ($0 payout) and your net profit is a loss of the $25 premium you paid.
Similarly, in the medium scenario where the stock price ends equal to the $5 strike price. You have the right to buy the stock at $5 from the option, or you could buy the stock for $5 in the market. Therefore, the payout from the option is still $0 and your profit is a loss of $25.
However in the high and very high scenarios, you can see what happens when the stock price finishes above the $5 strike. In the high scenario, the stock price moved from $4.50 on 1/15 to $6 on 2/15. That means that:
You have the right to purchase the stock at $5 that trades for $6 in the market. Therefore, you would execute the option, pay $500 to get 100 shares of the stock, and could immediately sell it for $600.
This results in a $100 option payout.
You paid $25 to purchase the option, so your net profit is $75.
The price of the stock went up 33% (from $4.50 to $6), however your return on the $25 cost is 300%. You achieved a significantly higher return.
If you look at the very high scenario, you can see that the option payoff scales linearly and there can be large asymmetric rewards.
Call Option Buyer’s Profit
The profit & loss from buying a call option is shown in the graph below. The gain on the option is on the y-axis and the stock price is on the x-axis. The line shows how the call option buyer’s profit increases as the price of the underlying stock changes from $0 to $10.
Takeaways from the call option buyer’s profit graph include:
At all stock prices below the strike price of $5, the option position loses $25
When the stock price = strike price, the option profit starts linearly increasing
When stock price = strike price + option premium, the option starts becoming profitable (crosses the x-axis, $5.25 in the above example).
The option payout increases dollar-to-dollar with the increases in stock price
Call Option Risks
The profits on call options can be big even for moderate moves in the underlying stock. But the large profits come with risks.
When buying a call option, you need to get both the direction and timing of the move correct. Otherwise the option expires worthless and all your premiums are gone.
Wrong on price action
If the stock stays below the strike price, the option expires worthless. Whereas, if you buy the stock directly, you would still have value.
In the above example for the medium scenario, if you bought the stock at $4.50 and a month later it was $5, you made a $50 profit vs you lost $25 on your $5 strike call option.
Wrong on timing
Your right that the stock price is going up, but wrong on how quickly. If the stock price doesn’t go up until after you option expires, then it doesn’t matter if you were correct on the stock movement.
In the above example, on 2/15 the stock is $5 and your option expires. But then on 2/16 the price doubles to $10, you were correct the stock was going up, but you got the timing wrong
Buying Call Option Summary
To summarize buying a Call Option means:
You want the stock price to go up before the maturity date
Your max loss is the price you paid to buy the call
Your max gain has no limit (in theory)
The option value increases $-for-$ with the underlying stock when over the strike price (in-the-money)
Back to our NFL betting. The ‘stock price’ is the current score differential. The ‘strike price’ is the spread. The ‘maturity’ is the end of the game. If you win the bet (GB covers the spread aka stock price > strike) you get a payout. If they don’t you lose your bet.
The only difference is with regular sports betting, it doesn’t matter if GB covers the spread by 1 point or 40 points, the payout doesn’t grow. However, with call options, the more you beat the spread, the higher the payout is.
Continue Reading On Options:
I was actually just looking at options the other day for Microstrategy. Everything here is well explained and easy-to-understand. Great article!