Call options enable the holder to purchase an underlying security at the given strike price by the expiration date, which is referred to as the expiry date of the option. If the asset holder does not want to acquire the asset, the asset holder is under no duty to do so. The buyer’s risk is restricted to the amount of the premium paid. Consequently, fluctuations in the underlying stock have no effect.
Buying options on a stock indicates that the buyer believes that the stock’s price will climb over the strike price before the option expires. If the investor’s positive perspective is fulfilled, and the stock price rises above the strike price, the investor may exercise the option, purchase the shares at the strike price, and immediately sell the stock at the current market price to earn a return on his or her investments.
The profit on this trade is equal to the difference between the market share price and the strike share price, plus the cost of the option, which includes the premium and any brokerage fees incurred in placing the orders. After multiplying the result by the number of option contracts acquired, the result is divided by 100, assuming that each contract represents one hundred shares. Unless the underlying stock price moves over the strike price before the expiry date, the option expires worthless and cannot be exercised. The call holder is not obligated to purchase the shares, but he or she will forfeit the price paid for the call.
Call Options are Being Sold
Writing a contract is the term used to describe the process of selling call options. In exchange for the premium charge, the writer gets an additional compensation. The writer (or seller) of an option, in other words, receives payment from a buyer for a premium. Selling the option at a premium result in a maximum profit of the premium earned. If a call option is sold in the open market, the investor is pessimistic and expects the underlying stock’s price to decline or stay reasonably close to the strike price of his or her option throughout the option’s duration.
If the current market share price is equal to or less than the strike price by the time the option expires, the call buyer will have lost all value in the investment. In order to make a profit, the option seller retains the premium received. Due to the fact that the buyer would not purchase the shares at the striking price that is greater than or equal to the prevailing market price, the option is not exercised.
But if at expiration the market share price is greater than the strike price, the seller of the option is required to transfer ownership of his or her stock to a purchaser of his or her stock at the lower strike price. As a result, the seller must either sell shares from their existing stock portfolio holdings or purchase a share of stock at the current market price in order to sell the option to the call buyer. A loss is incurred by the contract writer. In order to calculate the size of their loss, they must subtract the premium they got from the cost basis of the shares they must use to cover the option order. They must also subtract any brokerage order charges.
This shows that the risk exposure of call writers is much larger than that of call purchasers, as seen in the table. The premium paid by the call buyer is the only thing lost. Because the stock price may continue to climb indefinitely, the writer stands an insurmountable danger of incurring enormous losses.
Investing in Put Options
When a buyer purchases a put option, they are betting that the underlying stock’s market value will fall below the strike price on or before the expiry date of the option. Once again, the holder has the option to sell shares without being obligated to do so at the indicated strike price per share by the specified date.
Because put option purchasers want a fall in the stock price, the put option is lucrative when the underlying stock’s price is below the strike price of the option contract. If the current market price is less than the strike price at the time of expiration, the investor has the option to execute the put. They will sell shares at a greater strike price than the option’s strike price. If they decide they want to replace their current holdings of these shares, they may do so on the open market.
In this trade, their profit is equal to the strike price minus the current market price (plus expenditures, such as the premium and any brokerage commissions incurred in placing the orders). It would be necessary to multiply the result by the number of option contracts that were acquired, and then multiply the result by 100, assuming that each option contract represents 100 shares of stock.
Because of the decline in the value of the underlying stock, it is more valuable to hold a put option. The value of a put option, on the other hand, decreases when the stock price rises, and vice versa. It is possible to lose just the premium paid if a put option expires worthless, which limits the risk associated with purchasing put options.
An Example of a Preference
Consider the following scenario: Microsoft (MFST) shares are now trading at $108 a share, and you feel they will rise in value. You make the decision to purchase a call option in order to gain from a rise in the stock’s price. For 37 cents per contact, you acquire one call option with a strike price of $115 for one month in the future with a strike price of $115. To complete the position, you will need to spend $37 in cash plus fees and commissions (0.37 x 100 = $37).
If the stock price climbs to $116, your option will be worth $1 since you may exercise the option to purchase the shares for $115 per share and immediately resell it for $116 per share if the stock price rises to $116. As a result of paying 37 cents and earning $1, your return on the option position would be 170.3 percent, which is far larger than the 7.4 percent rise in the underlying stock price, which increased from $108 to $116 at the time of expiration.
In other words, the profit in currency terms would be a net of 63 cents or $63 since one option contract represents 100 shares [($1 – 0.37) x 100 = $63] and one option contract represents 100 shares [($1 – 0.37) x 100 = $63].
It is possible that the stock may fall below $100, and your option will expire worthless, resulting in a loss of $37 premium. The advantage is that you did not purchase 100 shares at $108, which would have resulted in a $8 per share loss, or a total loss of $800, had you done so. Clearly, options may allow you to reduce your exposure to downside risk.