Investment Strategies Part I: Call Options
Written by Gregory Steffens for Gaebler Ventures
Although many alternatives exist with securities, call and put options offer a variety of opportunities for firms to realize returns while minimizing the amount of risk involved. This article introduces the hedging instrument of call options.
For financial and strategic reasons, companies can benefit by investing their short-term or excess capital in call options.
If you are new to the world of derivates and puts and calls, we offer a primer on how call options work.
A call option gives the holder the right to buy an underlying asset from another party at a fixed price over a specific period of time.
Although options can be written on other assets like commodities, the majority of options are written on stocks. For a relatively small price, investors can profit from increases in a stock's price without having to first purchase the stock. When one buys a call option, he or she purchases the choice to buy another person's stock at a set price, called the strike price, for a specific period of time.
For American options, the holder has the right to exercise the call option at any time before the expiration date. Consequently, if the stock price increases at any time prior to its expiration, the holder can buy the stock at the strike price and instantly sell the stock at the higher market price for a profit.
Moreover, the option holder is not harmed by any decrease in the stock's price. If the stock price falls, he or she simply does not exercise the option and lets it expire. The most the holder of a call option can lose is the amount he or she pays for the option.
The profit profile is the exact opposite for the seller of a call option. The most the seller can profit from the option is the amount of the option premium he or she receives from the holder. In exchange for this payment, the option seller assumes the risk of any increases to the stock price.
As the graph figure below demonstrates, call options limit the downside risk for holders. If the price of the underlying stock decreases, the only loss comes from the price to purchase the option. However, if the stock price increases above $42.50, the break-even point, the option begins to increase in value and is considered in-the-money.
For the seller of the option, the opposite is true since he or she begins losing money as the stock price increases past $42.50. Moreover, the profit and loss potentials are limitless for both investors since the stock price can increase indefinitely. Because their design limits the potential losses of investors, call options can be used for a multitude of hedging strategies that will be introduced in subsequent articles.
Common Terms Involved with Options
Strike Price - The strike price, or exercise price, means the fixed price at which the option holder can sell the underlying asset. For instance, if an option has a strike price of $40 and the stock is currently trading at $45 a share, the option holder is $5 in-the-money.
Last Sale - The amount the last call option was purchase for.
Change - The amount the value of the option changed since the last trading day.
Bid - The price which one can sell a call option for determined by the market.
Ask - The price which one can buy a call option for determined by the market.
Bid/Ask Spread - The difference between the bid price and the ask price retained by the broker of the transaction.
Volume - The number of transaction that took place for the particular call option contract on the trading day.
Open Interest - The amount of open positions in the market for each particular call option.
Expiry - The expiry, or expiration date, means the month in which the call option must be exercised. For all calls, the option expires on the third Friday of the expiry month.
Long - The buyer or the position of owning an option contract.
Short - The seller or the position of selling an option contract.
In-the-money - Options that, if exercised, would result in the value received being worth more than the payment required to exercise. In other words, they make a profit.
At-the-money - An option in which the underlying value equals the exercise price. The option has no negative or positive value.
Out-of-the-money - Options that, if exercised, would require the payment of more money than the value received and therefore would not be currently exercised.
Option Premium - The amount of money the holder pays and the amount the seller receives for an option.
Gregory Steffens is a talented writer with a strong interest in business strategy and strategic management. He is currently completing his MBA degree, with an emphasis in finance, at the University of Missouri.
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