A call optionThe right, but not the obligation, to buy a stock at a certain price before the expiration date. is the option (remember, not an obligation) to buy 100 shares of a stock for an agreed price (the strike price The price at which the option contract can be executed.) by an agreed date in the future ( expiration date The date that the option expires, usually the 3rd Friday of the month in the U.S. ).
Here’s how it works: you buy one call option contract which expires in October for 100 shares in Yahoo! (YHOO) stock. For now, let’s assume that this call option was priced at $1.00, or $100 per contract. It now gives you the right, but not the obligation, to buy 100 shares of YHOO at $30 per share anytime between now and the 3rd Friday in October.
In the U.S., most equity and index option contracts expire on the 3rd Friday of the month. Also note that in the U.S. most contracts allow you to exercise your option at any time prior to the expiration date. In contrast, most European options only allow you to exercise the option on the expiration date!
If the price of YHOO rises above $30 by the expiration date in October, to say $35, then your options are “in-the-money” by $5 and you can exercise your option and buy 100 shares of YHOO at $30 and immediately sell them at the market price of $35 for a tidy $5 per share profit. Of course, you don’t have to sell it immediately—if you want to own the 100 YHOO shares, then you don’t have to sell them. Since all option contracts cover 100 shares, your real profit on that one option contract is actually $400 ($5 x 100 shares – $100 cost). Not too shabby, eh?
On the other hand, if the market price of YHOO is $25 in October, then you have no reason to exercise your option and buy 100 shares at $30 share for an immediate $5 loss per share. That’s where your option comes in handy since you do not have the obligation to buy these shares at that price – you simply do nothing, and let the option expire worthless. When this happens, your options are considered “out of the money” and you have lost the $100 that you paid for your call option.
Call options that are set to expire in 1 year or more in the future are called LEAPs and can be a more cost effective way to investing in your favorite stocks.
Always remember that in order for you to buy this YHOO October 30 call option, there has to be someone that is willing to sell you that call option. People buy stocks and call options believing their market price will increase, while sellers believe (just as strongly) that the price will decline. One of you will be right and the other will be wrong. You can be either a buyer or seller of call options.
The seller has received a “premium” in the form of the initial option cost the buyer paid ($1 per share or $100 per contract in our example), earning some compensation for selling you the right to “call” the stock away from him if the stock price closes above the strike price. We will return to this topic in a bit.