OPTIONS TALK: Kicking Goals with Call Options
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June 2, 2006
There are two types of options—calls and puts—that can be bought and sold by traders. In this article, I am going to go back to basics and explain how a call works using an analogy far from the financial markets.
A call option is the right or obligation to buy the underlying stock for a specific price by a predetermined date. To remove the ambiguity from the definition of the previous sentence; a scenario is presented below that illustrates how call options works.
Scenario: The Socceroos are about to compete in the World Cup and I have the chance to buy a jersey signed by the team for $10,000. If the Socceroos do well this will appreciate in value quite handsomely however if they lose every game the jersey will depreciate in value. I am uncertain how well they will perform. The jersey seller is happy to give me the option to buy the jersey at or before July 9 2006 for $10,000. For this right I must pay $1000 today.
Trade details
- Underlying- Signed Socceroos jersey
- Option Type- Call
- Strike Price- $10,000
- Expiration Date- July 9 2006
- Option Premium- $1,000
If the Socceroos do well and make it through the round of 16; the jersey is estimated to have a value of $15,000. As the option buyer I have the right to take delivery of the jersey for $10,000. I could take delivery of the jersey and then sell it at the market price for $15,000. This would result in a net gain of $4000 [$15,000 - $10,000 - $1,000] or return on investment [ROI] of 36%.
An alternative would be to sell my option to someone else. The option would have a value of at least $5,000 ($15,000 - $10,000) as this is the ‘real’ or ‘intrinsic value’. The ROI works out to be 400%.
Worse case scenario is the Socceroos do not perform well and get knocked out in the first round. Let’s say the jersey is now only worth $5000. As I am the buyer I have the right, not the obligation, to buy the jersey. I choose not to exercise my right and the contract expires worthless. The option seller keeps the jersey and the $1,000. I lose the premium paid, $1,000.
Put options work in a similar fashion except they give the buyer the right to be ‘short’ stock at a predetermined (strike) price. The put seller has the obligation to deliver ‘short’ shares at the strike price.
Sticking with the jersey analogy if I thought a country was going to perform poorly at the Cup I would buy a put option on a signed jersey. My maximum risk is limited to the premium paid for the put.
Apply the same principles as above, replace the jersey with stock and this is how call options can be traded in the share market. By buying calls or puts the options trader has limited risk and much greater potential reward than trading the underlying.
Go Socceroos!
Guy Halpin
Staff Writer
AU Optionetics
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