We’d be remiss if we didn’t offer as part of our options education series a quick rundown of one of the building blocks of all options strategies: the straightforward call purchase.
There’s slightly more here than meets the eye, so pay close attention.
First off, options are not a 50-50 proposition, as many think. Indeed, those who believe so will most likely end up losing a good bit of cash before they realize that, yes, a stock can either move up or down, but with options, one can be correct on market direction and still lose one’s entire investment.
How can that be? The answer to that question lies embedded in the very definition of an option and its price.
Let’s look at an example to get some clarity. Here’s six months’ worth of trading on Microsoft (NASDAQ: MSFT):
With the market selling off in mid-summer, it was only a matter of time before Microsoft shares also gave way. And indeed, Microsoft tumbled in late August from $47 to just below $40 in a matter of four trading sessions – a roughly 15% decline.
Being the savvy investor you are, you waited nearly two weeks to make sure there was little chance of further downside, and seeing the overall market also recovering, you decided it was time to act.
In the first week of September (red circle), with Microsoft trading at $43, you buy an “out-of-the-money” December $45 call for $2.50.
Before we continue, let’s consider some terminology.
The term “out of the money” refers to the fact that the option’s strike price is $45 and the stock is only at $43. It has to climb $2.00 in order to be at the money and beyond that level to be in the money.
The price of the option, $2.50, is comprised entirely of what’s termed “time value.”
In a moment, we’ll find out what that term means, along with the term “intrinsic value.” An option’s price, incidentally, is comprised of a combination of both time and intrinsic value.
Finally, Microsoft stock will have to be trading higher than $47.50 at expiration for you to break even on the trade. At that price, your option will be $2.50 in the money, the exact price you paid for the option at the outset.
Now back to the Microsoft rocket shot…
Toward the end of October, Microsoft reports stellar earnings and the stock gaps higher, hitting an intraday high of $54 on Oct. 23 (blue circle). You decide to bail out of the position, concerned the stock might retrench before the December expiry, leaving you with a whole lot less profit than you’re currently sitting on.
So, with Microsoft selling for exactly $53, you sell the option intraday for a wondrous $11.20.
That’s a net profit to you of $870 ([$11.20 – $2.50] x 100). (Remember, one options contract equals 100 shares of stock.)
But let’s take another look at the price of the option when you sold it. The stock was at $53, meaning your option was exactly $8.00 in the money ($53 – $45). That $8.00 also represents the option’s intrinsic value.
So how in the world did you get $11.20 for the thing?
Well, the remaining $3.20 represents the time value of the option, a sum that signifies the potential rise in the price of the option prior to expiration.
Note: Over the course of the trade, the stock climbed from $43 to $53, a rise of 23%. Your call option, however, rose from $2.50 to $11.20, a gain of 348%!
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