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Lesson 6. Stock Derivatives > Options - Pg. 30

Stock Derivatives 30 Calls By purchasing a call option, an investor is basically entering into a contract or agreement with the seller to purchase a stock at a predetermined price--the strike price. In gambling terms, you, the buyer, are betting that the price of the stock will go up; the seller of the option is betting that the price of the stock will stay the same or go down. Plain English A call grants the bearer the option of purchasing stock at a predetermined price in the future, regardless of the stock's actual market value at that time. It should be noted that the seller of the option doesn't necessarily have to own the stock for which he or she is selling the option. The seller of the option is responsible, however, for coming up with that stock for purchase at the strike price should the buyer of the option exercise, or use, the option. Should the stock be selling for a higher price on the open market, as is almost always the case, the seller would have to purchase the stock at the higher price and sell it for less than he or she paid for it. Leverage On the other hand, an investor can often make (or lose) more money by purchasing options rather than by purchasing the actual stock. This is the concept known as leverage. The basic premise of leverage is the same as a see-saw: The further you get from the center, or fulcrum, the more dra- matic the effects of movement. Leverage is explained in more detail in Lesson 9, "Opening a Bro- kerage Account," but let's see how the concept of leverage would work for an option. Say you want to purchase 10 shares of XYZ Company stock, which is currently selling for $10 per share. However, you believe that the price of XYZ Company stock will rise to $15 per share. You could spend $100 to purchase the stock and wait. If the price should rise to $15, your stock would be worth $150. Thus, you would have made a $50 profit; not bad for a day's work. But let's say you decide instead to spend the money to buy 100 options at $1 per option. These options grant you the right to purchase the stock at $11. Now, should the price rise to $15 as in the first example, your options have an intrinsic value of $400. In other words, for each share of stock you bought at $11, you would automatically make a $4 profit off the $15 open market price. Since you have 100 options, you can make $400 profit immediately by exercising your option. Or, even better, say you bought the 100 options for $1 and decided not to exercise them at all. Suppose you lacked the $1,100 needed to purchase those 100 shares at $11 in order to realize that $400 profit. You could always find another investor who wanted to purchase XYZ Company stock and offer to sell your options for $2 each (the dollar each you paid, plus a dollar in profit). You would make $100 and a 100 percent profit on the whole deal. The other investor would still save $200 on his or her purchase, and everyone would be happy. Well, unless you stuck with buying the stock instead of the options. Then you would make only $50 off the transaction. On the downside, however, let's say that you spend that $100 to purchase those same options. And let's say that the other investor uses his or her $100 to purchase those 10 shares at $10 per share. And, let's say that the price of the stock drops to $9 and doesn't go up. Since the price of the stock never reaches the strike price of $11, your options are never exercisable; so you lose all of your $100. The other investor loses money also, but at least his or her stock is still worth $90. Or, even more insulting, should the price of XYZ Company stock stay the same, you've lost everything, whereas the other person who bought the stock hasn't gained, but hasn't lost a dime either. You're still out $100.