What are Options?
What are Call Options?
Call Options give the option buyer/holder the right, but not the obligation, to buy shares of stock at the strike price during the term.
Call options make money when the stock rises above the strike price by an amount greater than the cost of the option.
The breakeven for a call option is the strike price plus the option price. Here is how it works. If you buy an option on stock symbol ABC, let's say the stock is trading at $100 per share. You think the stock is going to move up, so you buy the 100 call option that expires in 1 months time. The option ask price is $1.00. The option provides rights to 100 shares so you pay $1.00 for each share that the option controls. This makes your cost in real money $100.00.
For the cost of a single share, you obtain the right to profit on 100 shares if your right about the stock direction within the next month. Now let's examine the potential in three different scenarios.
Scenario 1. Breakeven
In this scenario, the stock moves up to trade at $101 per share. You paid $100 for the right to buy 100 shares at a price of $100 per share. You can exercise your right to buy the 100 shares at $100 each. This means you buy the shares for a total of $10,000. You can then sell those shares in the open market for $101 per share. If you do that for all 100 shares, you collect $10,100. This results in a transaction profit of $100. Since you paid $100 for the call option, this trade would end as a wash and you would break even on the trade.
Scenario 2. Loss
In this scenario, you are dead wrong about the direction of the stock. You find out that the CEO of ABC has embezzled a fortune from the company. It's a big scandal and over night the stock drops to 0. You are not happy, but you are happy that you bought the option instead of the stock. You remember that you have the right and NOT the obligation to buy the shares at $100 per share. You decide to let the option seller keep the shares and you say goodbye to your $100. The poor shareholder loses $10,000 and is now praying that the courts will be able to get some money back.
Scenario 3. Big Win
In this scenario, you were right on about the stock direction. ABC invented a very effective treatment for cancer and over night the stock has more than doubled in value. It's now trading at $201. The shareholder would have been up 101%. But you are an option buyer. And you are extremely happy about that today. You decide to exercise your right to buy the shares at $100 per share. You happily pay $10,000 and receive 100 shares. If you then sell those shares in the open market for $201 per share, you collect $20,100 a transactional profit of $10,100. You subtract the $100 you paid for the option and you just made $10,000 for a 1000% gain on a $100 investment.