Options refer to financial derivatives that give buyers the right, but not the obligation to either buy or sell underlying assets such as stocks, bonds, commodities, etc., at a predetermined price and date. These derivatives comprise call and put options. Put options allow buyers to profit when there is a decline in the price of the security while call options allow buyers to profit when there is an increase in the price of securities. Both call and put options are types of stock options. In this article, we will discuss call option examples, problems, and how it works; but what is a call option?
What is a call option?
Call options refer to financial contracts that give the option buyer the right, not the obligation to purchase an underlying asset at a specific price within a specific time period. These underlying assets are stocks, bonds, or commodity refers to the underlying asset. When the price of the underlying assets increases, the call buyer enjoys profits. We can contrast a call option with a put option which gives the holder the right to sell the underlying asset at a specific price on or before expiration.
See also: Early Exercise of Stock Options
Call options explained
A call option is commonly referred to as a call which is a form of derivatives contract that gives the buyer the right rather than an obligation to buy a stock as well as other financial instruments at a specific price. The seller of the option has the obligation to sell the financial security to the buyer if the buyer decides to exercise his option to make a purchase. The buyer of the option can exercise the option at any time before the date of expiration maybe three months, six months, or even a year in the future.
The seller receives the purchase price for the call option which is on the basis of how close the strike price is to the price of the underlying security at the time the option is purchased and on how long a period of time remains till the expiration date of the option. In other words, the option’s price is based on how likely or unlikely it is that the option buyer will have a chance to profitably exercise the option prior to expiration. Options are usually sold in lots of 100 shares. The buyer of the call looks forward to making a profit if and when the price of the underlying asset increases to a price higher than the strike price of the option.
The seller of the call option, on the other hand, hopes that the price of the asset will decline, or at least never rise as high as the strike price of the option before it expires in which case the money received for the sale of the option will be pure profit.
If the price of the underlying asset does not increase beyond the strike price before expiration, then it will be unprofitable for the buyer of the option to exercise it. In this case, the option will expire worthless or “out-of-the-money”. The buyer will suffer a loss that equals the price paid for the call option. Alternatively, if the underlying security or asset’s price rises above the option’s strike price it will be profitable for the buyer to exercise the option.
In essence, a fee called the premium is paid to purchase a call option. That is the price paid for the rights that the call option offers.
Buying call options give investors the ability to invest a small amount of capital to potentially gain profit from a price rise in the underlying security or to hedge away from positional risks. Small investors make use of options to try to turn small amounts of money into big profits while corporate and institutional investors make use of options to increase their marginal revenues as well as to hedge their stock portfolio.
Types of call options
- Long call option
- Short call option
Long call option
A long call option simply refers to a standard call in which the buyer has the right, but not the obligation to purchase a stock at a strike price in the future. A long call option is advantageous because it allows one to plan ahead to purchase a stock at a cheaper price. For example, one might purchase a long call option, anticipating that there will be a newsworthy event, say the earnings call of a company. In a long call option, profits are unlimited while the losses are limited to premiums. With this, even if the company does not report a positive earnings beat or does not meet the expectations of the market and there is a decline in the price of its shares, the maximum loss that the buyer of the call option will incur is limited to the premiums paid for the option.
Short call option
As the name implies, a short call option is the opposite of a long call option. Here, the seller promises to sell their shares at a fixed strike price in the future. Mainly, the seller uses short call options used for covered calls, or call options in which the seller is already in possession of the underlying stock for their options. The call helps to contain the losses that are bound to be suffered if the trade does not go their way. For example, their losses would multiply if they remain uncovered, that is, if they did not own the underlying stock for their option and there is a significant appreciation in the price of the stock.
Related: Capital Market Instruments, Examples, and Types
Terminologies in call option
- Current price and target price
- The strike price of a call option
- Price of the call option
- Amount of options contract
- Premium (total call options cost)
- Call potential profit
- Call potential return
Current price and target price
These are the prices of the underlying assets from which the call option derives its value. One can see the profits in the call option calculator considering the current price of the underlying asset in the market, or one can calculate possible profits if he has a target price in mind.
The strike price of a call option
The strike price is the predetermined price of the asset, say stock, at which, if the underlying stock’s market price goes over the agreed price, the call option can be executed. In other words, the owner of the call option has the right to buy the shares of the underlying asset from the option writer at the strike price irrespective of the current market price. The new owner of the shares could then sell them for a profit if they want. If the current price is greater than the strike price, we will say that the call option is in the money.
Price of the call option
The contracts of the option have their own price or cost which changes in accordance with market dynamics such as market positive and negative expectations, remaining time to contract option expiration, etc.
Amount of options contracts
The amount of options contracts refers to the number of contracts you are going to buy. It is important to have in mind that each contract represents 100 call options. This implies that if one buys four call option contracts, he gains right over 400 call options, thus, 400 shares of the underlying asset.
Premium (total call options cost)
The premium represents the total investment you will make for getting your desired amount of option contracts. This amount also refers to your capital at risk. If the stock’s current price is below the strike price, we say that the option contract is out-of-the-money.
Call potential profit
The potential profit refers to the profit one could make for the operation minus call option costs which are expressed in percentages.
Call potential return
The call potential return refers to the profit one could make for the operations minus call option costs expressed in one’s currency. It is important to note that even if the current price of the underlying assets is equal to the strike price, one will incur a loss due to the call option costs. When both stock price is equal to the strike price, we say that the call option is at the money.
Call option formula
Call option value
The value of a call option refers to the excess of the price at which the underlying asset can be sold in the open market which is the underlying price and the price at which the underlying asset can be bought (the exercise price). The value of a call option can never be negative because it is an option and the holder is not obligated to exercise it if it does not have any positive value.
The formula used in calculating the value of a call option is represented as;
Value of Call Option = max (0, underlying asset’s price − exercise price)
Call option payoffs
Call option payoffs refer to the profit or loss that an option buyer or seller makes from a trade. It is important to have in mind that there are three key variables to consider in the evaluation of call options. These variables are strike price, expiration date, and premium. These variables calculate the payoffs generated from call options.
Two cases of call option payoffs exist, these are;
- Payoffs for call option buyers
- Payoffs for call option sellers
Payoffs for call option buyers
If for example, you purchase a call option for Tesla for a premium of $2. The strike price of the option is $50, and its expiration date is the 30th of November. You will break even on your investment if the stock price of Tesla rea reaches $52. This means that the sum of the premium paid plus the purchase price of the stock. Any increase that occurs above that amount is considered a profit. Thus, the payoff when the share price of Tesla increases in value is unlimited.
What happens when the share price of Tesla declines below $50 by the 30th of November? Since your call options contract is a right and not an obligation to purchase Tesla’s shares, you can decide not to exercise it, this means that you will not buy the Company’s shares. In this case, your losses will be limited to the premium paid for the option.
Payoff = spot price – strike price
Profit = payoff – premium paid
Using the formula above, your profit is $3 if Tesla’s spot price is $55 on the 30th of November.
Payoffs for call option sellers
The calculation of payoffs for the seller for a call option is not very different. If you sell Tesla’s options contract with the same strike price and expiration date, you stand to gain only if the price declines. Your losses could either be limited or unlimited depending upon whether your call is covered or naked. The case of unlimited losses occurs when you are forced to purchase the underlying stock at spot prices or probably even more if the buyer of the options exercises the contract. In this instance, the sole source of your income and profits is limited to the premium you collect on the expiration of the options contract.
The formulas used in the calculation of payoffs and profits are as follows;
Payoff = spot price – strike price
Profit = payoff + premium
NOTE: The spot price is the current price in the marketplace at which the underlying asset can be bought or sold for immediate delivery.
Related: Stocks and Shares: Differences and Similarities
Call option examples
The following call option for Amazon stock has a strike price of $70 and a call option price of $7.50. Imagine being bullish on the stock and having seen that the cash conversion cycle has improved, so one wants to take extra gains on a very likely stock run.
Now, let us see how to calculate the call option profit when the target price is $82.40 and the desired number of contracts is 4. The data shows the following;
Target price (TP) = $82.4
Strike price (SP) = $70
Price of call option (PCO) = $7.5
Number of option contracts (n) = 4. It is important to remember that each contract contains 100 options.
The outcome will be as follows;
(i) Total option cost = PCO x n x 100
= $5.5 x 4 x 100
(ii) Call potential profit = TP – SP – PCO / PCOCall potential profit
= $82.4 – $70 – $7.5 / $7.5 x 100%
(iii) Call potential return = (TP – SP – PCO) x n x 100Call potential return
= ($82.4 – $70 – $7.5) x 400
Mr. Ben is a trader in an investment management firm. It is early May 2013 and speculation exists that Intel is launching a new processor that is expected to improve performance and reduce the consumption of power drastically. He believes that this improvement can help in reviving the sales of personal computers, but he is not sure. He bought 5,000 call options on Hewlett-Packard Company (NYSE: HP) and 1,000 call options on the stock of Dell (NASDAQ: DELL).
Relevant information is contained in the table below;
|Exercise Date||Exercise Price||Current Price||Premium|
|HP||June 20th, 2013||$22||$24.2||$2|
|DELL||June 20th, 2013||$14||$13.33||$1|
Using the information above, we will calculate the value of each call option that Mr. Ben will most likely exercise. On both call option trades also, net profit will be calculated if any.
In calculating the value of the call options for both HP and DELL, we will use the following formula;
Value of Call Option = max(0, underlying asset’s price − exercise price)
Value of call option on the stock of HP = max(0, $24.2 – $22) = $2.2
Total value of HP call options = 5,000 x $2.2 = $11,000
next, we will find the net profit on the call option on HP stock. The formula is;
Net profit = Total call option value – option cost
= 11,000 – (5,000 x $2)
Using the same formula;
Value of call option on the stock of DELL = max (0, $13.3 – $14) = 0
Total value of DELL call options = 1,000 x 0 = 0
The net profit on the call options of DELL will be;
Net profit = 0 -1,000 x $1 = -$1,000
Looking at the result of the calculations, Mr. Ben will most likely exercise the call options on HP stock because they have positive values. He can exercise the option to purchase 5000 stocks of HP at $22 per share and sell them in the market for $24.2 per share thereby realizing the gain of $11,000. However, the option cost brings about a reduction in this gain, that is the premium paid upfront.
For the options of DELL, Mr. Ben will let them expire as they are worthless. This is because it is unwise to buy DELL stock at $14 when it is available in the market for $13.3.
If for example, the stock of Microsoft is trading at $108 per share. Joshua owns 100 shares of the stock and wants to generate an income above and beyond the dividend of the stock. He also believes that shares are not likely to rise above $115 per share over the next month.
Joshua takes a look at the call options for the following month and sees that there is 115-call trading at 37 cents per contract. So he sells one call option and collects the $37 premium, that is, $0.35 x 100 shares, representing an annualized income of roughly 4%.
If the stock price rises above $115, the buyer of the option will exercise the option and Joshua will have to deliver the 100 shares of stock at $115 per share. Joshua still generated a profit of $7 per share but will have missed out on any upside above $115. If the stock does not rise above $115, he keeps the shares and the $37 in premium income.
Related: Advisory Shares Meaning and Example
Buying a call option
when buying a call option, you pay the option premium in exchange for the right to buy shares at a fixed price which is the strike price on or before the expiration date. Oftentimes, investors buy calls when they are aggressively confident in a stock or other securities because it offers leverage. In this context, leverage is the ability of options contracts to multiply the power of one’s capital.
The buyer of the call option is known as a holder who purchases a call option hoping that the price will rise beyond the strike price and before the expiration date. The profit earned is equal to the sale proceeds minus strike price, premium, and any transactional fees that are associated with the sale. If the price does not increase above the strike price, the buyer will not exercise the call option.
For example, assuming the stock of Company XYZ is selling at $40 and the call contract with a strike price of $40 as well as an expiry of one month is priced at $2, the buyer is then optimistic that the price of the stock will rise and then pays $200 for one XYZ call option with a strike price of 40. If XYZ’s stock increases from $40 to $50, the gross profit that the buyer will receive is $1,000 and a net profit of $800.
There are several factors that an investor should put into consideration while buying a call option. This activity entails more decisions compared to buying the underlying stock. One who has decided on the stock on which to buy calls should consider the following factors;
- Amount of premium outlay
- Strike price
- Time to expiration
- Number of option contracts
- Type of option order
Amount of premium outlay
This is absolutely the first step in the process as. In most instances, an investor would rather buy a call than the underlying stock because of the significantly lower cash outlay for the call.
The strike price is one of the two key option variables that need to be decided, the other is the time to expiration which will be explained in the next point. The strike price has a great impact on the outcome of the trade of your option. With this, there is a need to do some research on picking the right strike price. The general rule for a call option is that the lower the strike price, the higher the call premium. This is because you obtain the right to buy the underlying at a lower price. The more the call is out-of-the-money, the lower will be the call premium. Here, the strike price is at the money meaning it is equal to the stock’s current price.
Time to expiration
The time to expiration is is another key variable to be considered. For options, everything other thing being equal, the longer the time to expiration, the higher the option premium. Making decisions on the time to expiration involves a tradeoff between time and cost.
The number of option contracts
At the finalization of the strike price and the time to expiration, one will have an idea of the call premium. For example, with $1,500 to invest and with each one-month $50 call option which costs $300, it is critical to decide whether to buy five contracts for the full amount available at one’s disposal to invest or buy three or four contracts and reserve some cash.
Type of option order
As a derivative of stock prices, the prices of options can be volatile, therefore, there would be a need to decide whether one should place a market order or a limit order for his calls.
Selling a call option
The sellers of call options are also known as writers. they sell options hoping that they become worthless at the expiry date. They make money by keeping the price paid to them by the buyers, that is the premium. Their profit will reduce or may even bring about a net loss if the option buyers exercise their options profitably when the price of the underlying security rises above the strike price. Call options are sold in two ways namely;
- Covered call option
- Naked call option
Covered call option
A call option is said to be covered if the seller of the call option is actually in ownership of the underlying stock. Selling the call options on these underlying stocks brings about additional income and will offset any expected declines in the price of the stock. The seller of the option is covered against a loss since in the event that a buyer or holder exercises his option, the seller can provide the buyer with shares of the stock that he has already purchased at a price that is below the option’s strike price. The profit of the seller in owning the underlying stock will be limited to the stock’s rise to the strike price of the option. However, he will have protection against any actual loss.
Naked call option
A naked call option is a case whereby the option seller sells a call without having ownership of the underlying stock. Naked short selling of options is considered very risky because there is no limit to how high the price of the stock can go. Here, the option seller does not have any coverage against potential losses by owning the underlying stock.
When the buyer of a call option exercises his right, the naked option seller has the obligation to buy the stock at a current market price to provide the shares to the option holder. If the price of the stock exceeds the strike price of the call option, then the difference between the current market price and the strike price is a representation of the loss to the seller. Most option sellers charge a high fee in order to compensate for any losses that are bound to occur.
See also: Equity Options: Examples and Types
How to exercise a call option
Exercising a call option involves converting the call into stocks, this means that you now own shares. It is critical to use cash that will no longer be earning interest to fund the transaction or borrow cash from your broker and pay interest on the margin loan. In either of the cases, you are losing money with no offsetting gain.
With this, a buyer should exercise call options if he is using them to hedge a short sale as well as the presence of a continuous rise in the stock price. A short sale has to do with selling shares that one borrowed from his broker with the expectation of buying them back at lower prices. If the stock rallies, on the contrary, call options that have the appropriate strike price could prevent losses because one could exercise the calls to cover his short position. For example, if you sold short a stock at $20 and bought call options with a strike price of $20 at the same time, you could exercise the calls in order to cover your short position if the stock price increases past $20.
See also: Stock Options vs Equity: Differences and Similarities
Purpose of using call options
- Income generation
- Tax management
Investment banks as well as other institutions make use of call options as instruments for hedging. Hedging refers to an advanced risk management strategy that has to do with buying and selling an investment, to potentially help to reduce the risk of loss of an existing position. Just as it is with insurance, hedging with an option opposite one’s position helps in limiting the number of losses on the underlying asset or instrument in case an unforeseen event occurs. Therefore, one can buy call options and use them to hedge stock portfolios or sell them to hedge against a pullback in a long stock portfolio.
There are investors that use call options to generate income through a covered call strategy. This strategy has to do with owning an underlying stock while writing a call option at the same time or giving someone else the right to purchase your stock. The investor collects the premium of the option and hopes that the option expires worthless, which is below the strike price. This strategy generates additional income for the investor, however, it can also limit profit potential if the price of the underlying stock rises sharply.
Covered calls work because if the underlying stock price rises above the strike price, the buyer of the option will exercise his right to buy the stock at the lower strike price. What this means is that the option writer does not profit from the stock price rising above the strike price. The maximum profit of the option writer is the premium received.
Call options contracts give buyers the opportunity to obtain significant exposure to a stock for a price that is relatively small. Using these options in isolation, they can bring about significant gains if the stock rises. On the other hand, they can also result in a 100% loss if the call option expires worthless as a result of the underlying stock price falling to move above the strike price. The benefit of buying call options is that there is always a capping of risk at the premium that is paid for the option.
Through call options, holders potentially gain profits from a rise in the price of an underlying stock while paying only a fraction of the cost of buying the actual stocks of shares. They are a leveraged investment that brings about potentially unlimited profits and limited losses which is the price paid for the option. As a result of the high degree of leverage, call options are seen as high-risk investments.
Investors may as well buy and sell different options at the same time thereby creating a call spread. These will cap both the potential profit and loss from the strategy but in some cases, they are more cost-effective than a single call option because the premium received from the sale of one option compensates for the premium paid for the other.
Sometimes, investors use options to change the allocations of portfolios without actually buying or selling the underlying security. For example, an investor may possess 100 shares of Company X stock and may be liable for a large capital gain that is unrealized. To avoid triggering a taxable event, shareholders may use options to reduce the exposure to the underlying asset or security without actually selling it.
In the above case, the only cost that the shareholder incurs for engaging in this strategy is the cost of the options contract itself. Though the profits of options will be classified as short-term capital gains, the method for calculating the tax liability will vary by the exact option strategy and holding period.
In the money call option
A call option is in the money when the market price of the underlying stock is greater than the call option’s strike price. The call option is in the money because the buyer of the call option has the right to purchase the stock below its current trading price. When an option grants the buyer the right to buy the underlying stock below the current market price, that right then has intrinsic value. A call option’s intrinsic value is equal to the difference between the current market price of the underlying security and the strike price.
Generally, the more in-the-money an option is, the costlier it becomes to buy. This is unlike when it is out-of-the-money that will cost less, in essence, the more out-of-the-money the call options are, the cheaper they become. However, other factors exist that affect an option’s price such as volatility and time to expiration.
In-the-money call options have some advantages, one of which is the fact that the value of the option increases for many investors. The reverse is the case with out-of-the-money call options as they are highly speculative because they only possess extrinsic value.
Another advantage is that once a call option is in the money, it becomes possible to exercise the option to buy a security at a price that is less than the current market price. With this, it becomes possible to make money off the option regardless of the market conditions of the current options, which can be crucial.
Sometimes, parts of the options market can be illiquid. Call options on thinly traded stocks and call options that are far out of the money can be difficult to sell at the prices implied by the Black Scholes model. It is for this reason that it is beneficial for a call to be in the money. The fact remains that in-the-money options are usually the most liquid and frequently traded in part because they capture the transformation of out-of-the-money options into in-the-money call options.
Practically, it is rare to exercise options before the date of expiration because by so doing, their remaining extrinsic value is destroyed. The main exception is significantly deep in the money options where the extrinsic value makes up the total value’s tiny fraction. Therefore, exercising call options becomes more practical as expiration approaches and there is a dramatic increase in time decay.
In-the-money call option example
For example, a trader buys one call option on Samsung with a strike price of $35, with an expiration date one month away from the date of purchase. If Samsung’s stock trades above $35, the call option is said to be in the money. Assuming Samsung’s stock is trading at $38 a day before the expiration of the call option, then the call option is in the money by $3, which is $38 – $35. With this, the trader can exercise the call option and buy 100 shares of Samsung for $35 and then sell the shares for $38 in the open market. The profit of the trader will be $300 which is 100x $38 – $35, or 100 x $3.
Out-of-the-money call option
Out of the money is a term that is used to describe an option contract that only contains an extrinsic value. Generally, the delta of these options will be less than 0.50. Also, an out-of-the-money call option will have a strike price that is higher than the underlying asset’s market price. Alternatively, the strike price of an out-of-the-money put option is lower than the underlying asset’s market price.
One can tell if a call option is out-of-the-money by determining what the underlying stock’s current market price is in relation to the strike price.
A call option being out of the money does not mean that a trader cannot make a profit on that option. Each option has a cost, known as the premium. It is possible for a trader to buy an option that is far out of the money but as the option keeps moving closer to being in the money, the option can end up being worth more than the trader paid for the option even though it is currently out of the money. At expiration, however, an option is worthless if it is out of the money. Therefore, it is needful for the trader to sell it prior to the expiration date in order to recoup any possible remaining extrinsic value.
If we consider a stock that is trading at $10, call options for such stocks with strike prices above $10 would be out-of-the-money calls. On the other hand, put options with strike prices below $10 would be out-of-the-money puts.
Options that are out of the money are typically not worth exercising. This is because the current market is offering a trade level that is more appealing than the strike price of the option.
Out-of-the-money call option example
A trader intends to buy a call option on the stocks of Hisense. They choose a call option that has a strike price of $20. The option costs $0.50 and it is to expire in five months’ time. With this, they have the right to buy 100 shares of the stock before the expiration of the option. The total cost of the option is $50, which is 0.50 x 100 shares, plus a trade commission. Currently, the stock is trading at $18.50.
Upon the purchase of the option, there is no point in exercising the option because by exercising it, the trader will have to pay $20 for the stock when they can currently purchase it at a market price of $18.50. While this option is out of the money, it is not worthless yet because there is still potential to make a profit by selling the option instead of exercising it.
If for example, the trader just paid $0.50 for the potential that the stock will appreciate above $20 in the next five months, before expiration, the option will still have some extrinsic value. This is actually reflected in the premium or cost of the option. The underlying asset’s price may never reach $20 but the option’s premium may increase to $0.75 to $1 if it draws closer. Therefore, it is still possible for the trader to reap a profit on the out-of-the-money option itself by selling it at a higher premium than it was initially paid for.
If the price of the stock moves to $22, the option will now be in the money, here, the option is worth exercising. The option grants them the right to buy at $20 and then the current market price is $22. The difference between the strike price and the current market which is $2 is the intrinsic value.
Here, the trader will end up with a net profit or benefit as $0.50 was paid for the option, and that same option is now $2. The net profit or advantage is then $1.50.
Assuming the stock only rallied to $20.25 when the call option expired, the option is still in the money in this case, but the trader actually incurred a loss of money. $0.50 was paid for the option but currently, its value is only $0.25, resulting in a loss of $0.25 which is $0.50 – 0.25.
Break-even point of a call option
When one buys a call option, it is important to know where his break-even point is in order for him to know where he can potentially ring the cash register or profit from the trade. We have seen that a call option is a financial derivative or instrument that grants one the right to buy a particular asset (underlying asset), such as a stock, at a predetermined price before the expiration of the option. The break-even point is the price of the underlying asset at which one makes zero dollars, there is neither loss nor gain of money. One starts to gain profit from the trade when the price of the underlying asset exceeds the break-even point.
How to determine a call option’s break-even point
- Visit any financial site that provides quotes for options, type a stock’s ticker symbol into the option’s quote text box and click Get Options to have a view of a table of information on the options that are available for that stock. Pull up the information for options on stocks or other types of investments on the online trading platform of your broker.
- Look out for the strike price of your desired call option. The strike price, as earlier stated, is the price for which the option gives you the right, but not the obligation, to buy the underlying asset. For example, if the strike price of a call option on a stock is $25, you are entitled to buy the stock for $25 before the expiration of the option.
- Look out for the call option’s ask price, or premium, that is the amount required to buy the option. Let us assume in the example that the call option’s ask price is $3.
- Finally, add up the strike price and the ask price to determine the break-even point of the call option. To conclude the example, add $25 and $3 to get $28 which is the break-even point. This implies that the option will become profitable if the stock price exceeds $28.
See also: What is a Tracking Stock? Examples and list
Call option problems
- Time decay
- Bid and ask price problem
- Implied volatility
When one buys an option, both time value and intrinsic value exist in that option price. Intrinsic value moves the option on the basis of the price of the stock. The time value drops slowly as the option draws closer to the expiration date. Because of this, there is a need for an option buyer to have the intrinsic value go up faster than the time value to make any money.
If the intrinsic value does not go up fast enough to have this result, the stock could do what it wanted to do and still lose money. Buying more time value is the best way to combat this problem. If one has an option three months out of the time, the value will decay at a much slower rate than an option that is one month away from expiration.
Bid and ask price problem
A problem is also posed for option buyers by the bid and ask price, these are the two prices that exist when buying an option. The ask price is the price that one can buy it for while the bid price is the price that one can sell it for. The difference between these numbers or prices is referred to as the spread.
The price that one can buy an option is usually higher than the price that one can sell it for. There is a need for the option to go up above this gap in order to be able to make money. One can lessen this problem by not trading options with stocks that have a high spread. For example, it is obvious that if one finds a stock that has an ask price of $8 and a bid price of $6, that might not be good irrespective of the bond.
The implied volatility is very important to understand, it measures the volatility of a stock at a given time. It is also used to measure how volatile an option is. This can have an effect on the price because if one buys a call option with high volatility, the stock can go up, but if the volatility drops, the option’s price will be affected. In the same vein, if one buys a call option when the volatility is low, and the price of a stock goes down, there is a tendency to still be able to make money if the volatility goes up. In general terms, volatility goes down when stocks go up and it goes up when the prices of stocks fall.
Many traders of options believe that if a stock moves $1, the option should also move $1, but this is not the case. This is one of the greatest misconceptions that new traders have about options. The options will not move up exactly the same amount as the stock. In fact, an option greek exists, called Delta, that is designed to determine how fast an option should move. Here, if the Delta is $0.5, then it will move $0.5 for every $1 the stock moves.
Call vs put option
The call option and put option are opposite of each other. A call option, as earlier stated, is the right to buy an underlying stock at a predetermined price up until a specified date of expiration. A put option on the other hand is the right to sell the underlying stock at a predetermined price until a fixed date of expiration.
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