Alright! Hey everyone. This is Kirk here again from Option Alpha and in this video, we are going to go through call option contract basics. This is going to be a fun video. It’s going to be a little bit longer, but if you stick with me, I think you’ll understand a lot about call option contracts because we’re going to look at it from both sides which is really important to understand and also draw some really cool payoff diagrams, so you understand exactly how these call option contract work. All call option contracts are, are a leveraged product that gives you as the option buyer… And we’ll go through both sides here, the option buyer and the seller. It gives you the right, but not the obligation (so you have a choice, the right, but not the obligation) to buy stock at a certain price which we will call the strike price where you’re striking a deal, as I say. It gives you the right, but not the obligation to buy stock at a certain strike price by a certain expiration date (so, we’ll just put EXP) and in order to gain this right, (because it’s not totally free. You just can’t go out in the market and collect all these rights and abilities to buy a stock at certain prices by certain expiration dates) you have to pay a premium and in our case, we’ll say you’re going to pay a debit premium which means it’s going to cost you money in order to purchase the right for this contract.
Just to review. A call option gives you (as the option buyer) the right to buy stock at a strike price, so at a particular price by a certain expiration date that you choose for a debit or for a premium. That’s what’s called the option premium, but in our case, it’s the debit that is required. It’s an outlay of money that is required on your end as the option buyer. Now, because we know that there’s two sides to every trade, obviously, there has to be a seller in order for there to be a buyer, so as the option seller of a call option contract, you now have the obligation if it comes to that which it doesn’t always come to that. It’s just the obligation at expiration or if the contract is assigned. Oftentimes, you can trade these contracts away which we’ll talk about in other videos. But as the option seller, you have the obligation to sell stock to this option buyer at a particular strike price by a certain expiration date for a contract premium which we will call the credit that you will collect. Now, what you’ll notice about this… And this is what’s really important about option contracts, is that everything is very balanced. Everything that happens well for the option buyer happens not so well for the option seller and vice versa and we will describe this as we kind of build out this payoff diagram together. But what you have to understand first is that the seller is using the exact same strike price, the exact same expiration and the exact same credit that we find on the opposite end that we used as the option buyer for the expiration strike and the debit. Everything balances out as we go through. There’s truly a beautiful balancing act that happens between buyers and sellers of these different contracts when you get into them.
To describe a little bit more about what happens with the call options as you start entering these positions, I think it’s pretty effective to start using a payoff diagram and this really helps us understand exactly what happens at different price points as we near expiration. In our case, we have this vertical access here which is your profit and loss. This would be – you are at a zero or breakeven point and this would be – you’re making money some denomination and this would be – you’re losing money by some denomination. We’re going to write and draw out this payoff diagram for this call option contract. This horizontal line here is actually the different stock prices. We’ll think about it as a stock that is trading for say $100 here. It could potentially trade all the way up here to $110 and all the way down here to $90. As the stock trades in different ranges, if the stock goes down in price to $90 or if the stock goes up in price to $110, what impact does that have on our call option contract? First thing that we’re going to do is we’re going to start off with just some very simple assumptions for our call option contract. Now, remember, the strike and the expiration and the debit or credit are all the same. It just depends on which side of the contract you’re looking at. For the purposes of ours, we’re going to assume that the strike price of our contract is $100 and the expiration date is 30 days and the premium that the option contract requires is $1. We’re just going to keep it really, really simple. The strike price for our contract is $100, the expiration is 30 days from today and the premium that that contract requires to be paid by the buyer to the seller (the seller collects it, it’s paid from the buyer) is $1. Now, if you took our course and you watched our videos on option contract multipliers, this essentially means that the premium is effectively $100 at the end of the day, but we’ll still use the $1 because it relates to the strike price and to the actual share price a little bit better as we go through our description here. If I am the call option buyer, (and I’ll just use the green pen here to describe the payoff of the call option buyer) if I have now paid a debit of $1 and the stock is trading right now at $100 and I buy the 100 strike call option, that means that at expiration, if the stock was to trade right at $100, I would actually lose $1 on this contract.
Now, I want to walk through this because I think this is the really important point about describing the payoff diagram and starting with this particular data point right here and we can fill in the gaps later on. But what you’re doing as an option buyer is you are choosing to pay $1 of premium in order to get the right to buy stock at $100 which is the strike price in 30 days or really, anytime before that as well. But if at expiration, the stock started the entire cycle at $100 and ended at $100, you are actually worse off than if you had done nothing and that’s really the important point. That’s what sets this as the basis for this particular payoff diagram. If at expiration, the stock started at $100 and ended expiration at $100, all you had basically done as the option buyer is you collected or you paid a $1 premium which gave you no benefit because the stock ended and started at the same place. Now, if you are the option seller, at expiration, if the stock starts and ends at $100, you collected the $1 premium from the option buyer and so, you have a profit of $1 on your payoff diagram. At expiration, the best thing to possibly happen to you, you are obligated to sell the stock to the option buyer, but the option buyer never entertains the idea because the stock really didn’t move anywhere and as a result, you collected a $1 premium at expiration and that’s what you have. Now, clearly, the stock is going to move and clearly, things are going to happen, but this is a good place to start because it gives us a frame of reference for how things might happen if different scenarios were to occur.
Let’s say that after you got into this contract as the option buyer now, let’s say that the stock started to move down and ended the expiration cycle at $95 per share, so now the stock ends at $95 per share. Remember, your option contract gives you the right to buy stock at the strike price which is $100 per share, buy expiration for a debit of $1. If the stock closes expiration and is trading at $95, would it be financially smart to buy stock at the strike price of $100 per share? And the answer to that question is no. You would not buy stock at $100 per share which is your strike price when the stock is already trading at $95 per share. Instead, what you would do is you would just forfeit the right to that contract, let the premium go that you’ve already paid because you’ve already paid it to the option seller, forfeit all that premium and you would simply buy shares at $95. There’s no point financially to exercise this contract with the option seller and buy stock at the strike price of $100 a share when it’s already trading at $95. Now, would it be financially smart to buy shares at $94? No. Would it be financially smart to buy it at $96? No. Or $97? No. It wouldn’t be financially smart to do anything except buy shares at a price above potentially $100 which is the strike price. Any price below this level is a price in which you would not entertain the idea of exercising or making your contract good with the seller, exercising that contract with the seller and saying, “Yes, seller. Please sell me stock that I have the right to buy.” because all of these prices below that, if the stock ends anywhere below your strike price, it’s not financially smart for you to do that.
If you are the option buyer now, anytime that the stock closes lower than your $100 strike price, you will always lose… And that will be the max amount that you lose. You will lose your $1 premium that you paid. This is why we start this entire discussion with this $1 premium and we go all the way out. No matter what happens, the stock could go all the way to zero, but you have the right to buy stock at $100. If the stock goes all the way to zero, then you’re still not going to entertain your idea or your contract of buying stock at $100. You’re just going to let the stock go to zero and the only money that you lost in this as the option buyer is the $1 premium that you paid to the option seller. Now, the same thing is true on the opposite end. You can see that it’s starting to become a little bit of a mirror type distribution or payoff diagram. As the option seller, you collect $1 and only $1 as your maximum potential profit as long as the stock closes at $100 or lower. At $100 or lower, it’s no longer financially feasible for you to sell stock to the buyer because they could just go out in the open market and buy stock at a cheaper price. The buyer just lets their contract expire, lets it go, lets it go through expiration, doesn’t exercise their contract and so, you as the option seller, you get to keep that entire $1 premium that you collected from the option buyer.
This is all still pretty simple and pretty easy to understand at this point. Where it gets a little bit more complicated is when we start looking at the stock closing at strike prices that are higher than the strike price of the contract. Let’s assume that in this case, the stock closed expiration at $102. This is a pretty simple example of how we can look at now, the cost involved in the option contract relative to how much you could potentially make. In this case, the stock started the expiration cycle at $100. It closed the expiration cycle at $102. Now, at expiration, you have a decision as the option buyer in this case. You have this contract that you’re holding which gives you the right to buy stock at $100 per share. The stock is now trading at $102 per share. Just on that alone, you would probably choose to exercise your contract because in that example, the stock is trading higher than the strike price. You exercise your contract with the seller. You say, “Mr. seller, I’d like to exercise my contract. I want to buy stock at $100 which is the strike price we agreed on, buy the expiration date that we agreed on.” and the seller is obligated to sell you stock at $100. You buy stock at $100 and you could immediately, if you wanted to, sell it back in the open market for $102. Now, that essentially creates initially, a nice $2 profit because you buy the shares at $100, you sell the shares back in the open market at $102, so it creates a nice little $2 profit.
However, what was the cost involved in getting into the contract? If you remember, it actually cost you money to get into the contract. It wasn’t free. You actually have to take that total gross profit, if you will, and you have to reduce it by the cost of the contract which was $1. Now, your net profit in this case is still $1. It is still financially smart and feasible for you to go ahead and exercise this contract. You’re going to make $2 selling the shares back in the open market for $102 when you bought them for $100, but because it cost you $1 to get into this contract, this means that your net profit is just $1. If we actually now take this line and move this line vertically up here, you can see that our net profit is $1 at $102 and as an option seller, you have basically the inverse of that happening. If you get to expiration and the share prices are $102, you’re going to be assigned to that option contract, you’re going to be obligated to sell stock at $100 and you’re going to be forced to buy stock to complete that trading loop potentially if you don’t have the stock at $102. And so, what that creates for you is it creates for you a negative $2 loss on the shares themselves. However, you did collect a premium from the option buyer of $1 initially. At the start of this, you collected this credit that was paid from the option buyer which means that your net loss on this position is exactly $1. And again, what you should notice and take note of is that these numbers are exactly the same, just in inverse for option contracts. Again, what happens well for the option buyer happens not so well for the seller and vice versa. Now, as the option seller, your payoff diagram looks like this. If the stock closes at $102, now you lose $1 on the contract net of the cost of the contract or the credit and the premium that was paid by both parties.
What you’ll notice as we start going through this very simple example is that whether you are the call option buyer or whether you are the call option seller, there is a very definitive breakeven point that occurs and that breakeven point occurs where it’s financially responsible or smart to actually exercise or not the contract at expiration. In our case here, the breakeven point is easy to calculate. It’s just simply the strike price of the option contract, plus the premium that was paid for the option contract which gives us a breakeven point on this of $101. Now, that breakeven point is exactly the same for both sellers and for buyers. That is the point at which you really have no financial gain or loss by going through the expiration or assignment process. Think about it. If you are the option buyer and the stock closes at $101, you could buy shares at $100 and sell them for $101, but you did pay a premium of $1 which means that you really have a net zero gain or loss. And so, that is the point at which the stock actually breaks even or the payoff diagram breaks even for the position. Now, obviously, the more expensive the option premium, the wider the breakeven point becomes for the call option buyer. If this call option premium, for example, was $11 and instead of $1, that means that the breakeven point on this position would actually be $111. In order for you to make money as an option buyer, you need the stock to close well above $111 and if it’s trading at $100 right now, you might think to yourself, “Well, what’s the likelihood of that happening?” These are all important things to understand, but if you just understand the very basics of it to start with, where these breakeven points come from and how they are derived, for both buyers and sellers, you have a much better understanding of exactly what happens with these payoff diagrams as we continue to move forward. I’ll put this back here. This is the option premium.
Now, let’s go through another example here and start talking about what would happen if the stock closed at $105. If you are the option buyer in this case… And this should be a little bit easier to understand obviously as we keep going. If you are the option buyer… Again, remember, you have the right to buy a stock at a strike price which is $100 by expiration and you paid a debit or a premium of $1 to get that right. The seller has the obligation to sell stock at the strike price of $100 by expiration if the buyer chooses and for their risk that they take on, they received a credit initially upfront. Now, let’s assume that the stock closes at $105. Well, if the stock closes at $105, as the option buyer, you would definitely exercise your option contract. You would buy stock at $100 which the seller is obligated to sell you and you would sell that stock in the open market for $105 and get an immediate profit of $5. You buy stock at your strike price. You sell it for $105. You get a total gross gain on the stock itself of $5. However, you did have to pay a $1 premium which is right up here to the option seller in order to execute this contract which means that you still have a nice profit of $4 for this particular option contract. If we now go further, you can see that this line just continues to go up in perpetuity and it’s an unlimited potential for profit. As the stock continues to move higher, this line just vertically continues to go up at the same pace. The opposite thing happens for the option seller. The option seller now has a loss of $5 because they have to go out and somehow buy the shares to give to you at $105 and you only pay them $100, so they lost $5 per share, but they did collect that $1 option premium which means that their loss, net loss after all the transactions that happens between the shares and the option contract was still $4. Again, it’s the exact same as the option buyer, just in reverse and you can see that the option seller’s risk in this case is unlimited to the downside because as the stock continues to go higher and higher and higher, these lines continue to move at their same trajectory and same pace in both directions continuing to move. This is the essential payoff diagram for a call option contract. This green line is your payoff diagram for your call option buyer which is the complete inverse, a mirror image of the payoff diagram for a call option seller and how we get to these numbers is actually just very simple math that we did based on where the stock is at expiration.
A couple of important notes about call option contracts. One, call option contracts have defined risk for option buyers and undefined (notice how it’s actually the exact opposite) risk for call option sellers. For call option sellers, there is defined profit, so the profit is defined for a call option seller and there is undefined profit, unlimited profit for a call option buyer. Again, this is very simple stuff if you actually take the time to understand exactly how all these things happen. The other thing you have to understand is that the point at which the payoff diagram pivots in both cases… And I use the word pivot because that’s where it actually starts to change from being flat to somewhat of a slope or being flat to somewhat of a downward slope. The pivot in the payoff diagram happens at the strike price. This is where the pivot happens, right here at the strike price and this happens for both call option buyers and call option sellers. And then the last thing that we’ll go through here and just the basics to review again, is that the breakeven point, the point at which it becomes either no longer feasible or potentially feasible depending on which way you look at it, either profitable or unprofitable for both the option buyer or seller, is the breakeven point which is calculated as the strike price, plus the premium that was paid. If you’re the option buyer, it’s the same point as the option seller as far as a breakeven. It’s the point at which you start making money as an option buyer and you start losing money as an option seller. Now, we did go through a lot in this video on call option basics and I hope that this was really helpful for you and if it was, please let me know in the comments or like or share or give us a thumbs-up, so that we know that this was really helpful for you. There’s a lot more that goes into options trading, obviously and we have a ton of courses that are free on Option Alpha that go into a lot more of these details, but I hope that this video was at least the starting point for you in your journey of understanding what call options are, what option contracts are and how they actually work in the market. As always, if you have any questions, please let us know and until next time, happy trading.
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