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The right to buy a stock at a certain price (referred to as the striking price) by a specific date, at the option’s expiration, is provided by a call option, but not the obligation to do so. The call seller will be paid a sum of money known as a premium by the call buyer in exchange for this right. Instead of continuing to exist indefinitely like stocks, options expire and either become worthless or have some value. The following characteristics make up an option’s primary characteristics:
- Strike cost: The cost at which the underlying stock can be purchased
- Premium: The option’s cost, whether paid by the buyer or the seller
- Option lapses and is settled at expiration.
Each contract for an option is equivalent to 100 shares of the underlying stock. When the stock price is higher than the strike price at expiration, call options are “in the money.” By putting up money to buy the shares at the strike price, the call owner can exercise the option. Alternately, the owner might simply sell the option to another buyer for its fair market value before it expires.
When the premium paid for a call is less than the spread between the stock price and the strike price at expiration, the owner of the call makes money. For illustration, suppose a trader paid $0.50 for a call with a $20 strike price, and the stock is $23 when it expires.
The trader has generated a profit of $2.50 ($3 minus the cost of $0.50), making the option worth $3 (the $23 stock price minus the $20 strike price).
The call is “out of the money” and expires worthless if the stock price is lower than the strike price at expiration. Any premium collected for the option remains with the call seller.
