Call options represent control of 100 shares of a certain stock. Their value is derived from the underlying stock. Options trade in contracts. Thus, if a call option contract trades at $5 and you buy 10 contracts then the actual cost is: $5 times 100 times 10 equals $5,000 plus commission. You hold a call option by simply purchasing it. You exercise it by taking possession of the stock shares. Options trade mostly on the Chicago Board Options Exchange, or CBOE. The mathematical model for options pricing originated with Fischer Black and Myron Scholes in the late 1960s and was concluded in 1973. The Black-Scholes Model has remained almost unchanged.
Understand that call options are a wasting asset like your car insurance. You pay an insurance premium for a given time frame then it expires. Options have an expiration date on the Saturday after the third Friday of the listed month at a given strike price -- the price that you want the underlying stock to trade at, or above, by expiration. A call option for stock “A” that trades at $5 and expires in February with a strike price of $20 per share is a, “February $20 at $5.”Step 2
Determine the time value of the call option. They are “in the money,” “at the money” or “out of the money.” These are the relationships between the actual price of the underlying stock and the strike price of the contract. Ideally, the price of the stock should be above the strike price -- in the money. The equation and mnemonic is P-I-T. Premium minus intrinsic value equals the time value. Intrinsic value is how much the option is in the money. If the option is at or out of the money, then the intrinsic value is zero, meaning the call has a time value equal to the premium.Step 3
Realize because options trade in their own secondary market that holding them too long can be a disadvantage. That is, stock “A” trades at $20 per share but the call option contract trades at $5. Control of 1,000 shares costs $500 plus commission. Ownership of 1,000 shares costs $20,000 plus commission. A simple example of a decrease in leverage and profit: Stock “A” trades at $20 per share and the Feb. 15 call options trade at $8 per contract. Hypothetically, there is approximately four months until expiration. The intrinsic value is $5. The time value is: $8 minus $5 equals $3. Yet, if the share price of the stock is stagnant as the call options nears expiration, the time value and premium decreases.Step 4
Know when to exercise the call option. Call options have a finite life so they must be sold as an options contract, exercised in order to take possession of the stock or allowed to expire. Most times, because options provide leverage, they are traded as financial instruments in their own right. Yet, options in the United States are “American-style” so the contract can be exercised on any trading day before they expire. This seems to negate the leverage aspect of the option but not always. An example is when the life of the call option overlaps with a dividend payout. The price of the stocks shares decrease by the amount of the dividend, thus, lowering the price of the call option. By exercising the option early, you will avoid the potential loss on the options premium.
- Research the equities and options markets thoroughly before investing any money.
- Trade on paper before you trade for real.
- It is entirely possible to lose your entire investment in options.
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