What Call options are.
In our general introduction we have seen that options, when used with speculative purposes, are completely comparable to bets on an uncertain future event, while the key difference from normal securities is that their value depends from another financial instrument.
In other words, when you buy for example a share you are betting on a company’s trend directly in real world economy while when you buy an option your focus is on the share’s value. We can say at a glance that they are financial instruments who’s value depends from other financial instruments’ trend. In fact they belong to the derivatives family.
But what really makes options unique in the derivatives landscape is the pay-off structure. Just to make things immediately clear, what is a pay-off…? Nothing easier to explain: when and how much you make profit or loss. So let’s start immediately by seeing how Call options work and then we can analyze Put options.
Also in this case, we will start from the classical definition. Intending to be generic, it ends up being quite complex. Nevertheless we have to state it, we must give some shred of certainties to all the people who consider ”form” important. Personally, I would suggest you to skip it and continue from the next paragraph:
A Call option is a contract which gives the owner the right but not the obligation to buy a given financial instrument in a scheduled future moment at a previously fixed price.
Feeling confused…? It’s normal, don’t worry, so let’s go on with…
An example with call option.
Once done with our homework, let’s really try to understand how things work. We’ll start borrowing an example from football.
One evening we’re at the pub in front of a good beer. We’re about at 2/3 of the championship and you believe our team, now scoring 40 points, will go far beyond 50 point within the end of the season. I believe exactly the contrary. So our expectations are:
Well, we have all the necessary ingredients for our Call option on the championship.
We find an agreement like this: you offer me a small beer now which means you pay straight away, let’s say 3$. If at the end of the championship our team will totalize a score lower or equal to 50 points you lose the bet and I’ll owe you nothing. Vice versa, if the score will be higher than 50 points, I’ll have to pay you a fixed amount, for example 1 $, for each extra point.
Well, this kind of agreement is exactly a call option on the championship result. Specifically, as you paid at first and will earn money only if the uncertain event will happen, you have bought a Call option while I have sold it. In financial terms you are long of Call and I am short.
Following you’ll find the structure of your revenues:
As you initially pay 3 $, your profits and losses will have the following dynamics:
Obviously, since I am your direct counterpart, my profits and losses will work exactly the other way round. But before we go further, let’s take the chance to see some technical terms (they are not really necessary but can help to understand each other faster from now onwards …and also show off a bit…).
- The championship is the so called underlaying of our agreement.
- The 50 points which have to be scored by our team are called strike price or exercise price.
- The small beer or the 3 $ at the beginning are called premium.
- In case of victory of your bet, when you’ll get back to me to collect your money, we’ll say you are exercising the option.
- The moment in which you can exercise the option is called expiration date of the option.
- To be specific, if we agree you can exercise your option at any moment as long as we get to 51 points, we’ll be speaking about an American option. On the contrary if you have to wait until the end of the championship in order to gain your profit, we’ll be speaking about an European option.
Now let’s contextualize…
Call options on financial markets.
The mechanism on financial markets is exactly the same. The only difference is the object of our agreement: why should we choose a championship that moves so slow from a week to another, when we can choose an exciting financial instrument who’s value changes each second…? We both know that this second case brings much more risk and consequently loads more pleasure..!
Since we are on the web and it’s about time to make a proper financial example, the most logical thing to do is to consider a Google stock. So, imagine to be in front on your trading platform, you are watching the Nasdaq quotation and you see that Google is currently quoted 40 $. After a bit you get bored of just watching and decide to buy from me a 50 $ strike price Call, paying a 3 $ premium.
Like in our previous agreement on the championship, if Google at the option expiration date, lets say in 3 months, will be worth 57 $ I will have to pay you the difference between the market value and the exercise price we have negotiated, as to say 57 – 50 = 7 $.
Vice versa if the security will be quoted lower than 50 euro, your expectations are wrong and I will keep my initial 3 $ premium.
As follows you can verify your earnings and the pay-off structure on the basis of the security’s trend. Obviously you will not see anything new, since values are the same as the previous example:
The same from my side, but with reversed values since, like before, I am your direct counterpart.
Buying a Call option.
Generalizing the concept, for the Call option’s buyer the profit is given by the value of the underlaying (security, commodity, exchange rate, etc) at the expiration date minus the strike price (in our example the value to score above which I have to pay you). While the eventual loss is represented by the premium the buyer has initially paid for.
Graphically the pay-off can be represented in this way (note: be careful because, I don’t know why, but this graph, used by most of the financial books, puts the possible values of the underlying on the horizontal line while the profits and losses on the vertical line):
Selling a Call option.
If vice versa you consider the option from my point of view, that is the case of the Call option’s seller, the pay-off structure works obviously the other way round. I immediately cash the premium and this is my profit but if the underlaying grows above a certain value, I’ll have to pay the difference between the market value and the strike price.
In order to calculate the profit or loss, we also have to consider a couple of obvious things but….you never know so it’s best to specify:
- The first. No need to say that in case you buy ten call options on the security instead of just one, you will have to multiply the eventual profit and the initial premium by ten.
- The second. Depending on the market which you choose to trade on, it can happen that the option/underlaying ratio is not one to one, but for example 100 to 1. What does it mean…? Easy. A call option can have as underlying not one but 100 Google shares. Of course in this case we’ll have to multiply our profit by 100 to have the correct value.
By the way, it may be useful for you to know that the total of the underlaying is called in financial terms “notional“.
At this point we’ve done the most. Having clarified the general framework, we just need to get a bit deeper with one remaining aspect. In our previous examples we have mentioned the hypothesis of a direct agreement between us, fixing the strike price on the Google share at 50 $. Well, as you can imagine, on the financial markets it doesn’t exactly work this way…
Call options: quoted strike prices.
On the official options markets there are thousand of traders negotiating different amounts of options with different underlaying and different prices: a direct agreement between each of them would understandably create a huge mess. That’s the reason why options strike prices are usually fixed by the organization that manages and regulates the market.
Getting back to our initial example on the Google stock quoted 40 $, it can easily happen that the only strike prices you can trade are 35, 40, 45 as well as 39, 40 and 41. This aspect depends on the market you choose to trade on but surely this way makes easier to find a match between demand and supply. Anyway, no fear, generally there are strikes for any taste.
If you have paid attention, right now you may have noticed that I have just mentioned strike prices above the market price as well as below it. Well, let’s conclude this part of the tutorial introducing some financial terms. In specific, we’ll speak about:
- Call options out of the money: when the underlaying market price is below the strike price. It’s the case of the example we referred to until now: the security value is 40 and we trade a strike of 50.
- Call options at the money: when the stock market price is at the same level of the strike. Getting back to our example, Google’s market price is 40 and we trade a contract with a 40 strike.
- Call options in the money: when the strike price is even below the underlying’s market price. In other words, when the security is quoted 40 and we trade a strike equal to 39.
Graphically speaking:
Having introduced these terms, we have definitely gone through the whole story. I’ve just one more doubt: maybe options in the money have left you a bit puzzled. You could say.. “but how…? If I can buy at 39 something whith an actual value of 40, I already have a profit…!”
Partially correct. It’s one of those cases in which what goes out the door gets back in from the window. That’s because you’re forgetting on the other side I am asking for a premium. If I ask you 3 $ for the 50 $ strike price option, I’m going to quote the one with strike 39 not less than 14 $. Which is the result..? Obvious: in both cases you won’t make any profit before the security reaches 53 $.
The price I have indicated may not be sharply precise, but it’s just to give you a good idea. Further on we will see how to calculate the correct option price. For now my suggestion is to proceed through this mini guide in order to see how Put options work and, having seen the mechanism of Call options, it’s going to show up much easier than you think.
