How Call Options Work

What are stock options?

There are two types of options: a call and a put. But before we go into the specifics of each, let’s take a moment and just discuss the term “options”.

An option in it’s simplest form is a contract to buy or sell a specific stock at a specific price for a specific amount of time.

Once you have these four components: 1. an agreement to buy or sell stock 2. a set price 3. a specific amount of time and 4. a cost, then you have an option contract.

Understanding the two types of option contracts – Call Options

Call Options are one of the two types of option contracts. In general, if you are buying a call option you expect the stock to go up. 

So let’s break down of how this works in an example:

Let’s say you have an iPhone 6 (64gb) and now Apple no longer makes the iPhone 6. What if I came to you and said I want to buy your iPhone 6 and I’m willing to pay $200 for it, but I don’t want it today, I want the right to buy it from August 1st, 2016 until October 31st 2016.

You say that is okay, but since I have to hold it just for you, to show you are serious you need to leave me a $50.00 non refundable deposit.

Let’s break down the contract here:

Stock = iPhone 6 (64gb)

Specific price = $200

Time frame = roughly 90 days, from August 1st, 2016 – October 31st, 2016

Cost = $50.00

We now have an option contract. Let’s try and understand the roles of the two people as you may be wondering why would anyone ever do that.

Person No. 1 – The Buyer of the Contract (me):

Why would the buyer like to enter into this contract?

1st reason: The iPhone 7 is rumored to come out in September, but critics say it will not have a headphone jack and will be made of cheaper material. The buyer believes the iPhone 6 will go up in price since there will no longer be a 64gb being made, and people will be outraged that there is no headphone jack. He believes the iPhone 6 will sell for minimum $400 after the news is released. He wants to lock down or control the phone for $50.00. He does not know for sure if the new phone will be better or worse, but he wants control over the phone just in case. 

2nd reason: Perhaps the iPhone 6 value will drop as much as a $100 if the new iPhone 7 is a hit. The buyer does not want to hold onto the phone waiting for the news to be released, he just wants to control the phone and have the right to buy it later if he or she chooses to. Because let’s say I didn’t do an option contract, but instead just purchased the iPhone 6 outright for $200.00. But if the new 7 comes out and it is a hit, no one wants the 6 anymore so the price drops to $100.00. How much money did I loose? I lost $100.00 because I already gave the seller $200.00. Rather than take the risk of buying the iPhone 6 and waiting to see what happens, I would buy an option for $50.00. If the new 7 is a hit, all I lost was $50.00 controlling your phone. I limited my risk. If it goes higher, great, if not, I only lost $50.00. 

3rd reason: The buyer currently does not have the $200 bucks to buy the phone but still wants in on the deal. No matter if the price goes up or down – he wants the option to buy the phone and sell it or keep it for himself. He wants to control the opportunity for 90 days to decide if the new 7 is a hit or not. 

Learn the reasons why the seller is interested in call options and some misconceptions about options debunked by listening to the podcast or reading the rest of the blog post by clicking here.

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