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As everyone knows, there are two types of transactions - buying and selling.
Consequently, there are also two types of options. One type of option 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, using a stock as our asset. The stock we are going to use is General Electric. We're not using GE because we feel that it is the right stock to trade. Instead, we chose GE because of its widespread familiarity. To make things simple, let's assume that GE shares are 100. We didn't choose 100 because that's the current price of GE. Instead, we chose 100 because it's a nice round number. After all, it's far easier to learn about a new topic when the name is familiar and the numbers are easy to work with.
Let's say it is October and you think the market will rally into the end of the year. General Electric shares tend to rise and fall with the market, so you think that GE will go up with the market. Let's assume GE is currently trading at 100 (the actual price of GE is not 100, but let's use this familiar stock and this nice round figure as an example). Let's also assume that you want to acquire the right to buy GE shares if they increase in value during this seasonally favorable time period. 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 GE shares at 100 before the December options expire on December 20, no matter how high or how low GE shares are.
The seller of the option, who will be obliged to deliver to you the shares of GE if you ask for them, requires compensation for giving you the right to buy GE at 100. The compensation you give him (e.g., the price of the option you pay) is called the option premium. The price of the option in October is 5. That's 1/20th of the price of the stock itself. So your out-of-pocket expenses are substantially reduced when compared to buying the stock. Here is a graph of the value GE December 100 call.
Notice that the call option's value is zero until the price of GE climbs above the exercise price of 100. Let's look at a couple of data points to see how the graph got its shape.
If GE shares are trading at 80 and you owned the call, 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 GE is 80? Therefore, when GE shares are at 80, the option has no "exercise" value. In this case, it would be worthless at expiration.
How about if GE is trading at 90? Same thing. No one would want to pay 100, as is your right, if you can buy GE in the open market at 90.
In both instances, there is no value in exercising the option. This brings up a term that you will hear 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 GE shares were at 100? In this case, it really doesn't matter. You could either buy the shares in the open market for 100, or exercise your option for 100. At the very least, one could state that there is no added value to exercising the option, so it is essentially 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 GE 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 GE 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".
This next graph is a graph of the profit/loss of the same option. Remember, the option cost 5, so if you bought it, you paid 5. Whenever you buy anything, that's a debit to your account. So the profit/loss of the option is the value minus the debit. With the stock at 120, the value is 20. So the profit loss would be 20 - 5 = 15.
Remember, the option starts gaining value once GE shares start climbing above 100. But notice how the line does not cross the zero mark until the price of GE reaches 105. This is the option purchase's breakeven. In other words, if GE finishes below 105, the option buyer loses. That's because the option does not gain enough value to overcome the purchase price. If it finishes above 105, the option buyer will earn a profit.
Notice that the breakeven price is equal to the price of the option when purchased (5), plus the option's strike price (100) [ 5 + 100 = 105]. This is a very simple rule of thumb for calculating the breakeven of a call purchase. The breakeven of a call purchase is equal to the price of the option plus the option's strike price.
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