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Today, we’re going to discuss buying a call option contract, which is the exact opposite of buying a put option contract. We’re going to illustrate the mechanics of buying call options using buying real estate as an example.
You are house shopping and find a house that you are interested in purchasing but do not want to buy it until later. You approach the seller of the house and tell the seller that you are interested in purchasing the house for $100,000 but not for another month. You write out terms of an option contract with the seller agreeing to sell you the house for $100,000, locking in the price, for the next month. This contract is the equivalent of a call option.
No matter what the market price of the house is in a month, the seller will have to sell you the house for $100,000 because of the contract you executed. However, since you are locking in a price with the seller and are the sole person who can purchase the house in the next month, you have to compensate the seller by paying a premium, say $5,000.
If in the next month, the market value of the house goes up to $150,000, you still have an agreement to purchase the house at $100,000 so you essentially made $45k, consisting of the $50,000 increase to the fair market value of the house minus the $5,000 premium that you pre-paid the seller.
On the other hand, if in the next month, the market value of the house goes down to $75,000, you don’t have to purchase the house. You simply walk away from the contract because you have the right, but not the obligation, to buy the house. In this case, you just lose the $5,000 that you paid in advance as the premium for the “call contract.”
This same principle can be applied to stocks: If you think a stock price might go up in the future, you can buy a call option to lock in the current or lower price at which you wish to buy the stock. Similarly, for the right to buy the stock at a lower price, for some fixed future period, you have to pay a premium to the option seller.
Example:
You want to own 100 shares of XYZ stock, but you want to buy them in the future. It is currently trading for $50 per share. You think the price might go up to $60 per share in the near future, so you buy a call option contract to buy 100 shares of XYZ stock for $50 per share, locking in the price for the next month or so. For the right to buy at $50, you have to pay a premium of $1.25 per share.
XYZ stock goes up to $60 per share one month later. However, you can still buy the stock at $50 per share because you have an unexpired call option. In this case, you make the difference between $60 and $50 less the premium of $1.25 that you paid for the option. Your net profit would be $8.75 per share.
XYZ stock goes down to $45 per share. Since you have an unexpired call option to buy at $50, you would just walk away from the contract. You would be better off buying the shares at $45, since it’s cheaper than $50. You still lose the $1.25 per share that you paid in premium, but that’s a trivial cost of doing business!
If you found this article helpful on the basic concept of a call option or you have any questions, leave a comment below!
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