Let’s say that you were interested in purchasing 100 shares of a company. In this example we will use Google (GOOG). Let’s say for this example that the price of GOOG is $400 per share. Let’s also say you expect Google to go up significantly in the near future, due to something new coming out or any other factors.
You could create a call option in which you agree to buy 100 shares of GOOG stock for $405 per share from another investor. The agreed upon price is known as your strike price. The agreement would be good for a set period of time, let’s say one month for this example. You would pay the other investor a premium for the right to buy GOOG at any time during this period, let’s say $4 per share, or $400 up front.
Your breakeven point would be $405 per share plus the $4 per share premium, so $409. If at any point during the one month expiry period GOOG goes above $409 you will be in the money. Let’s say GOOG goes to $450. You would be buying the shares for $409, earning you a $41 profit per share, or $4100.
If on the other hand GOOG stays below $409 per share, you will not have any reason to exercise your option as you could buy it on the free market for less. You will then be out the original $400 you paid up front for the option. The seller doesn’t even have to own the investment that the option covers. If GOOG went to $500 per share in that month, the seller would have to buy it on the open market for $500 per share, losing $91 per share.
The premium paid for the option is kept by the seller free and clear if the option isn’t exercised. This premium covers the risk involved by the seller and makes the deal more even.