Options and Calls

We’ve learned about stocks, so now let’s transition to options!

What’s an option?
An option is a type of derivative that gives the buyer of the option the right to buy or sell one hundred shares of stock at a given price (known as the strike) for a given amount of time until expiration. In layman’s terms, it is in sorts a hedge that buyer/seller is insured against price fluctuations in the market for a certain amount of time.

Why is an option a derivative?
Most liquid stocks have a corresponding option contract. The price of the option is primarily driven or derived by the price of the stock, but other factors like strike price, time duration, implied volatility, and prevailing interest rates, for example, play a significant role in deciding the theoretical price determination of an option.

What do I do with an option?
Well, there are many options. (Pun intended) There are two types of options: call options and put options. Just as you can buy and sell stocks, you can buy and sell options. These operations can be combined, and will be discussed in future strategies, but for today let’s break down the mechanics of buying a call option.

Buying calls:

By buying a call option, the buyer can purchase units of stock at the set strike price, when the current market value of the stock is greater than the strike price at or before expiration.

What does this mean?

When buying or selling any option there are three key elements: premiums, strike prices, and expirations.  When buying a call option the buyer must pay a premium, or a small fee, to the seller. This validates the options agreement between the two parties of the options contract. The buyer sets both a strike price and expiration, and is matched with a seller in the market who has set the same values for his/her transaction. The strike price, in the in the instance of the buying a call, is the maximum amount of money the buyer is willing to spend when purchasing units of stock. The expiration date, set by the buyer, is the period  in which the contractual agreement between the buyer and the seller is upheld.


By paying a premium fee to the seller, the buyer of the call may buy the units of stock from the seller, if the price of the stock reaches or exceeds the set strike price within the time period/before expiration.

The probability of success with options is determined by the movement of the stock. For buying calls, if the stock's price...

• Increases to strike price + option premium= You break even! OR Increases above break even price= You profit!
• Stays the same= The time value, or theta, of the option's premium decays over the passage of time.  As the contract approaches expiration, the time value portion of the stock decreases. This is a not beneficial to the buyer of the call option.
• Decreases below the original price= The buyer of the call incurs the loss of the decaying option price as well as the premium paid for the option. 

In summary, a buyer of a call option is profitable in 1/3 cases, causing them to have a 2/3 chance of losing, as the stock could either stay the same or go down. On the bright side, the max loss the buyer will incur is the premium paid for the call option.