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Example of a call option on a stock
Payoff from buying a call.
Payoff from writing a call.An investor typically 'buys a call' when he expects the price of the underlying instrument will go above the call's 'strike price,' hopefully significantly so, before the call expires. The investor pays a non-refundable premium for the legal right to exercise the call at the strike price, meaning he can purchase the underlying instrument at the strike price. Typically, if the price of the underlying instrument has surpassed the strike price, the buyer pays the strike price to actually purchase the underlying instrument, and then sells the instrument and pockets the profit. Of course, the investor can also hold onto the underlying instrument, if he feels it will continue to climb even higher.
An investor typically 'writes a call' when he expects the price of the underlying instrument to stay below the call's strike price. The writer (seller) receives the premium up front as his or her profit. However, if the call buyer decides to exercise his option to buy, then the writer has the obligation to sell the underlying instrument at the strike price. Often the writer of the call does not actually own the underlying instrument, and must purchase it on the open market in order to be able to sell it to the buyer of the call. The seller of the call will lose the difference between his or her purchase price of the underlying instrument and the strike price. This risk can be huge if the underlying instrument skyrockets unexpectedly in price.
The current price of ABC Corp stock is $45 per share, and investor 'Chris' expects it will go up significantly. Chris buys a call contract for 100 shares of ABC Corp from 'Steve,' who is the call writer/seller. The strike price for the contract is $50 per share, and Chris pays a premium up front of $5 per share, or $500 total. If ABC Corp does not go up, and Chris does not exercise the contract, then Chris has lost $500.
ABC Corp stock subsequently goes up to $60 per share before the contract is expired. Chris exercises the call option by buying 100 shares of ABC from Steve for a total of $5,000. Chris then sells the stock on the market at market price for a total of $6,000. Chris has paid a $500 contract premium plus a stock cost of $5,000, for a total of $5,500. He has earned back $6,000, yielding a net profit of $500.
If, however, the ABC stock price drops to $40 per share by the time the contract expires, Chris will not exercise the option (i.e., Chris will not buy a stock at $50 per share from Steve when he can buy it on the open market at $40 per share). Chris loses his premium, a total of $500. Steve, however, keeps the premium with no other out-of-pocket expenses, making a profit of $500.
The break-even stock price for Chris is $55 per share, i.e., the $50 per share for the call option price plus the $5 per share premium he paid for the option. If the stock reaches $55 per share when the option expires, Chris can recover his investment by exercising the option and buying 100 shares of ABC Corp stock from Steve at $50 per share, and then immediately selling those shares at the market price of $55. His total costs are then the $5 per share premium for the call option, plus $50 per share to buy the shares from Steve, for a total of $5,500. His total earnings are $55 per share sold, or $5,500 for 100 shares, yielding him a net $0. (Note that this does not take into account broker fees or other transaction costs.)
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