A call option is an agreement between a buyer and seller that allows the buyer to buy stocks, bonds or other investments at a certain price by a certain date. The buyer has no obligation to ever make a purchase and will pay a premium to the seller up front for the right to buy if conditions prove favorable.
The agreement is based on a strike price, which is what the buyer is willing to pay. Even if the investment goes over the strike price, the buyer still has a choice as to whether or not they would like to exercise their option. If the buyer decides against exercising their option, they will be out the upfront premium paid for the option. The only obligation lies in the seller, also known as the writer. If the buyer chooses to exercise their option, the seller must deliver what was agreed upon.
The buyer in a call option is betting that a stock, bond or other investment will go up in value before the expiration of the option, also known as the expiry. If the investment becomes more valuable than the agreed upon strike price, the buyer can buy the investment from the seller and then sell it for a profit or hold on to it if they anticipate it will continue to rise in value.
The seller is betting that the investment will stay the same or possibly even go down in value. If the investment never goes above the strike price, the buyer will not exercise their option, leaving the seller with the premium paid up front for the option. Sellers aren’t even required to own the investment they are contractually obligated to deliver. The seller must purchase the stocks, bonds or other investment instruments to deliver to the buyer if they don’t already own them. This can cost the seller a lot if an investment skyrockets in value quickly, as they will have to purchase it at a much higher price to deliver to the buyer at the agreed upon strike price.
For example, if ABC Corp stock is currently at $50 per share and an investor Brian (Buyer) expects it to go up quickly, Brian will buy a call contract for 100 shares of ABC Corp from Steve (Seller). The strike price will be set at $55 per share, or $5500 total for 100 shares. Brian (Buyer) pays Steve (Seller) $550 as an upfront premium for this agreement. If ABC doesn’t go up, Steve profits $550 in premiums. If ABC goes up to $60 per share, Brian will profit $5 per share, or $500.
In this case, if Steve (Seller) didn’t already own ABC Corp, he would need to buy it at $60 per share, or $6000. Brian (Buyer) paid $550 up front and will pay $5500 for the shares, leaving Steve will just $50 for his efforts. If the stock had gone to $70, Steve could have lost $950. If the stock fails to go up in value by the expiry, Steve gets to keep his premiums free and clear without ever owning any stock, bond or other investment instrument.
The breakeven point for the investor (buyer) is when the investment rises above the value of their strike price plus the additional premiums paid for the option. In this case, it was when the stock hit $60.50 as he would be paying $55 for the share plus the $5.50 in premiums. Anything above $60.50 would be a profit for the buyer and anything below would be a profit for the seller. This of course doesn’t account for any additional fees such as broker fees and additional transaction fees.