Call Option how it is used.

January 11th, 2012

admin

Call Option

There are also two types of options, a Call option and a Put Options.

So far we’ve covered the type that gives the buyer of the option the right to buy the asset. That type of an option is known as a call option.

It is called a call option because the owner of the option can do just that, call away the underlying asset. That is, the option owner can call upon the seller of the option to deliver the asset, provided the option buyer pays the agreed upon exercise price. The seller (also called the grantor) of a call option has the obligation to sell the asset to you at the preset price.

Let’s look at an example of a call option, this time using a stock, instead of real estate, as our asset.

It is October. You think that the market will rally into the end of the year. Widgets and Co shares tend to rise and fall with the market, so you think that Widgets and Co will go up with the market. Let’s assume Widgets and Co is currently trading at 100.

You want to acquire the right to buy Widgets and Co shares or in this case a call option if they increase in value between now and the Christmas holidays, so you buy a call option with a strike price of 100 and an expiration date of December 20.

Remember, the strike price is the price at which the option can be exercised. This means that you will have the right to buy Widgets and Co shares or in this case a call option at 100 before the December options expire on December 20, no matter how high or how low Widgets and Co shares are.

The seller of the call option, who will be obliged to deliver to you the shares of Widgets and Coif you ask for them, requires compensation for giving you the right to buy Widgets and Co call option at 100. The compensation you give him (e.g., the price of the call option you pay) is called the option premium.

The price of the call option in October is 5. That’s 17/20th of the price of the stock itself. So your out-of-pocket expenses are substantially reduced when compared to buying the stock.

Now let’s fast forward to December. Let’s look at what the call option will be worth as Widgets and Co shares fluctuate. Remember, the December call option with a strike price of 100 gives you the right but not the obligation to buy Widgets and Co shares at 100 before December 20. If Widgets and Cos hares are trading at 80 on the New York Stock Exchange, would you want to exercise your right, call away the stock and pay 100? Of course not.

Why would you want to pay 100 when the market price of Widgets and Co is 80? Therefore, when Widgets and Co shares are at 80, if the call option has no “exercise” value. In this case, it would be worthless at expiration. How about if Widgets and Co is trading at 90? Same thing.

No one would want to pay 100, as is your right, if you can buy Widgets and Co in the open market at 90. Therefore, when Widgets and Co shares are at 90, the option has no “exercise” value. In this case, it would be worthless at expiralion. In both instances, there is no value in exercising the option.

This brings up a term that you will here more about, “out-of-the money”. Out-of-the-money options are options that have no value if the option were to be exercised. What if Widgets and Co shares were at 100? In this case, it really doesn’t matter. You could either buy the shares in the open market for 100, you could exercise your call option for 100. At the very least, one could state I1 ml there is no added value to exercising the option, so it is essenlittlly worthless.An option whose exercise price is identical to the current market price is said to be ”at-the-money”.

How about 110? You could exercise your right to “call” away Widgets and Co and buy it at the agreed upon exercise price of 100 and then instantly sell the shares in the open market at 110. In this case, you make 10 from exercising your option. Options that can be exercised for any value are called in-the-money options.

Finally, what happens if Widgets and Co shares go to 120? Again, you could exercise your right to “call” away and buy the shares at 100, sell them at 120, making 20 from the exercise.

This “exercise value” goes by another term used by option traders. It is called “intrinsic value”.

Here is a plot of the option’s intrinsic value:

Notice that the call option’s value is zero until the price of Widgets and Co climbs above 100.

Let’s take a look at a commodity option now.

In this case, let’s look at soybeans. It is May. Soybeans are trading at $7.00 per bushel. You think soybeans are going to go up during the summer and into harvest. You buy a November $7.25 call.

November stands for the expiration month. In futures options, however, the expiration month corresponds to the expiration of the futures contract, not the option.

So in this case, the November expiration corresponds to the November soybean futures expiration. November soybeans options actually expire in October. To get a calendar of option expirations, you can contact the various exchanges or a brokerage firm.

The exercise price, or strike price, in this instance is 7.25, but it is abbreviated to 725 on most quote machines and in the financial newspapers.

Let’s go through our valuation exercises.

If soybeans were 6.00, would you exercise the option to buy them at the exercise price of 7.25? No way, why would you exercise your right to buy them at 7.25 when you can buy them in the market at 6.00? The option has no intrinsic value with brans at 6.00.

How about when soybeans are at 7.00? Nope. Soybeans can be l -I M i I used in the open market for 7.00. No need to exercise your option to buy at 7.25 when you can buy them at 7.00. The option i” mi intrinsic value with soybeans at 7.00.

What if soybeans are at 8.00? Absolutely! You can exercise your option to buy soybeans at 7.25, and immediately sell them for 8.00. You earn 75 cents per bushel from the exercise of the option.

If soybeans are at 9.00, you do the same thing! You can exercise your option to buy soybeans at 7.25, and immediately sell them for 9.00. You earn $1.75 per bushel from the exercise of the call option.

Here is a plot of the call option’s intrinsic value: