Make money with call options
What exactly is an option?
An option on an underlying asset, such as a stock, is the right to buy or sell that underlying asset at a specified price within a specified period of time. A call option represents the right to buy. The opposite is a put option, which entitles you to sell. In both cases there is only a right but no obligation to trade, which distinguishes options from futures. For more information on call options, see this post.
types of options
Options differ first according to their underlying value. It can be a share, but commodities and other values are also possible. A distinction is then made between options according to the type of permitted exercise. American call options certify the right to buy within the term, European options can only be exercised with a purchase at the end of the term. The difference is smaller than it might seem because an option can be traded as a security during its lifetime. If you want to exercise a European option before the end of the term, this corresponds to selling this option.
Possibilities of call options for investors
The price of an option, i.e. the option premium, is very often much lower than the price of the underlying asset itself. This is also plausible, because the option, in contrast to ownership, only allows a significantly restricted disposal of the underlying asset. This means that the investor can earn a price gain of this value as a return with much less capital than for an acquisition of the underlying asset.
Conversely, the investor’s risk is naturally high. If the price of the underlying develops differently than the investor had predicted, the option is worthless and a total loss of the invested capital occurs. This is the case with a call option if the price of the underlying falls. Then the option to buy is worthless if the spot price on the market is lower than the agreed strike price of the option plus the option premium.
Behavior of call options in different price movements
The investor purchases a call option. He thus benefits from a rise in the price of the underlying asset. The maximum loss is the capital used for the option premium, the possible gain is just as unrestricted as the price increase of the underlying asset.
The investor sells a call option. He then benefits from a fall in the price of the underlying. In this case, the option holder will let the option lapse and the investor reaps the option premium. If the investor does not own the underlying asset and has to purchase it on the spot market when exercising the option, the loss in this case is just as limited as the price increase of the underlying asset.
This way of selling an option is less risky if the investor owns the underlying asset and can expect the price to remain the same or fall.
The prices of options
When trading options, the limit to profitability depends on the option premium. Exercising an option only pays off if the price moves so far in the predicted direction that at least the option premium accrues as a return.
But how do you determine a realistic price as an option premium? A first heuristic consideration is that the premium should increase with the intensity of the currently observed fluctuations in the price of the underlying asset. Then you expect a higher probability that the strike price of the option will be reached.
Of course, this is by no means sufficient for a quantitative formulation. In 1973, economists Fischer Black and Myron Scholes proposed what they called the Black-Scholes formula for determining the option premium. However, it only applies if certain assumptions are met, which is often, but not always, the case. For other cases, the question of a realistic price for an option is still an interesting area of research today.
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