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Friday, April 28, 2006

Options groundwork

This post explains how a financial call option works. If you already understand call options skip this post. I plan to use the concept extensively in later posts.

A call option is a type of derivative that grants the owner the right, but not the obligation to purchase an asset at a fixed price and at a fixed time in the future (the expiration date). A put option works the same for selling an asset. The value of the option depends on the price of the asset, the volatility of the asset and the time until the option expires. Volatility measures how likely the asset is to fluctuate in price.

A textbook example of a call option has XYZ Corp stock (the asset) selling for $50 a share today. Lets say you think XYZ stock is going to rise significantly in the next six months. You could buy XYZ corp stock for $50 today and hold it for 6 months, or you could buy a 6 month call option.
Consider two cases: 1) a call to buy the stock at $50 in 6 months that costs $7, and 2) a call to buy the stock at $60 in 6 months that costs $3. Here is where your predictive powers come into play.
  • If you think the stock will get over $57 ($50 strike + $7 call price) but not over $63, buy the call in 1).
  • If you think the stock will rise to over $63 either call will be profitable.
  • If you think the price will rise above $67.5 the call in 2) will produce a higher return.

Let's say you buy a call option and the stock rises to $70 in 6 months. The option from 1) is worth $20. [The option lets you buy a $70 asset for $50.] Since you paid $7, your return is $13 or 186%. The option from 2) is worth $10, but you only paid $3 so your return is $7 or 233%. Compared to the buy and hold strategy which saw the $50 investment rise to $70 for a 40% return, the options really outperform when things go your way (people call this phenomena leverage).
Be aware that things can go wrong. If in 6 months time the stock only rises to $55 (+10 return for buy and hold), the call in 1) is only worth $5 which represents a loss of $2 or 29% and the call in 2) is a total loss.

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