How Call Option Buying Works

When you buy a call, you are not required to buy the 100 shares of stock. You have the right, but not the obligation. In fact, the vast majority of call buyers do not actually buy 100 shares of stock. Most buyers are speculating on the price movement of the stock, hoping to sell their options at a profit rather than buy 100 shares of stock. As a buyer, you have until the expiration date to decide what action to take, if any. You have several choices, and the best one to make depends entirely on what happens to the market price of the underlying stock, and on how much time remains in the option period.

Using calls to illustrate, there are three scenarios relating to the price of the underlying stock, and several choices for action within each.

1. The market value of the underlying stock rises. In the event of an increase in the price of the underlying stock, you may take one of two actions. First, you may exercise the call and buy the 100 shares of stock below current market value. Second, if you do not want to own 100 shares of that stock, you may sell the option for a profit.

Every option has a fixed value at which exercise takes place. Whenever an option is exercised, the purchase price of 100 shares of stock takes place at that fixed price, which is called the striking price of the option. Striking price is expressed as a numerical equivalent of the dollar price per share, without dollar signs. The striking price is normally divisible by 5, as options are established with striking prices at five-dollar price intervals for stocks selling between $30 and $200 per share. Stocks selling under $30 have options trading at 2.5-point intervals; and stocks trading above $200 per share have options trading at $10 intervals. When a stock splits, new striking price levels may also be introduced. For example, if a stock is split 2-for-l and it has a current option at 35, the post-split levels would be adjusted to 17 1/2. (In cases of splits, the number of shares and options are adjusted so that the ratio of one option per 100 shares of stock remains constant. In a 2-for-l split, 100 shares become 200 shares at half the value; and each outstanding option becomes two options worth half the pre-split value.)

Example

Profitable Decisions: You decided two months ago to buy a call. You paid the option price of $200, which entitled you to buy 100 shares of a particular stock at $55 per share. The striking price is 55. The option will expire later this month. The stock currently is selling for $60 per share, and the option's current value is 6 ($600). You have a choice to make: You may exercise the call and buy 100 shares at the contractual price of $55 per share, which is $5 per share below current market value; or you may sell the call and realize a profit of $400 on the investment, consisting of current market value of the option of $600, less the original price of $200. (This example does not include an adjustment for trading costs, so in applying this and other examples, remember that it will cost you a fee each time you enter an option transaction, and each time you leave one. This should be factored into any calculation of profit or loss on an option trade.)

2. The market value of the underlying stock does not change. It often happens that within the life span of an option, the stock's market value does not change, or changes are too insignificant to create the profit scenario you hope for when you buy calls. You have two alternatives in this situation. First, you may sell the call at a loss before its expiration date (after which the call becomes worthless). Second, you may hold on to the option, hoping that the stock's market value will rise before expiration, which would create a rise in the call's value as well, at the last minute. The first choice, selling at a loss, is advisable when it appears there is no hope of a last-minute surge in the stock's market value. Taking some money out and reducing your loss may be wiser than waiting for the option to lose even more value. Remember, after expiration date, the option is worthless. An option is a wasting asset, because it is designed to lose all of its value after expiration. By its limited life attribute, it is expected to decline in value as time passes. If the market value of the stock remains at or below the striking price all the way to expiration, then the premium value—the current market value of the option—will be much less near expiration than at the time you purchased it, even if the stock's market value remains the same. The difference reflects the value of time itself. The longer the time until expiration, the more opportunity there is for the stock (and the option) to change in value.

Tip

In setting standards for yourself to determine when or if to take profits in an option, be sure to factor in the cost of the transaction. Brokerage fees and charges vary widely, so shop around for the best option deal based on the volume of trading you undertake.

Example

Best Laid Plans: You purchased a call a few months ago "at 5." (This means you paid a premium of $500). You hoped that the underlying stock would increase in market value, causing the option also to rise in value. The call will expire later this month, but contrary to your expectations, the stock's price has not changed. The option's value has declined to $100. You have the choice of selling it now and taking a $400 loss; or you may hold the option, hoping for a last-minute increase in the stock's value. Either way, you will need to sell the option before expiration, after which it will become worthless.

Tip

The options market is characterized by a series of choices, some more difficult than others. It requires discipline to apply a formula so that you make the best decision given the circumstances, rather than acting on impulse. That is the key to succeeding with options.