Options are a form of a derivative.  This means that they derive their value from something else.  For example, if you buy a stock, you are buying a part of a company.  You are entitled to future earnings and assets.  The company has value and that is reflected in the price of the stock.

If you buy a CALL option on that stock, you have the right to buy that stock at a certain price by a certain date.  You do not have an obligation to buy the stock, it is your choice.  There are a few variables that go into the price of the call option and for now I will keep it simple.  The main variables are the Strike Price, the Expiration Date and the Price of the Stock.

Lets look at General Electric (GE) as an example.  On February 19, 2009 GE closed at $10.04 Bid/$10.05 Ask.  The following is a list of near the money Call options that expire in March 2009.

Call Options - General Electric February 19, 2009

Call Options - General Electric February 19, 2009

 

If you purchased one March $5 Call (symbol GEWCE) for $5.20 (plus transaction costs) today, you would have until the March 20th (the third friday of March) Expiration date to EXERCISE the option.  If you exercise the option, you would owe your broker $5.00 (plus transaction costs) and you would own 100 shares of GE.

Why would you do this?

Perhaps you think GE is going to announce something that will make the stock rise between now and when the option expires, but you do not have the $10.06/share to buy the stock today.  This position would only cost you $5.20 today and $5.00 later. 

If GE makes an announcement and the stock falls to $4.00/share, you will have lost the $5.20/share that you paid for the option and it will expire worthless.  If you had purchased the stock, however, you would have lost $6.06, and still own a stock that could be headed lower.

Lets look at the risk/reward graph, at the expiration date.

$5 March 2009 GE Call

$5 March 2009 GE Call

If GE stock is above $10.20 (plus transaction costs) the options will produce a gain.  If GE stock is below $5, the options will expire worthless, and the maximum loss of $5.20 will be realized.  In between $5 and $10.20 the options will incur some loss,  up to $5.20.

If we compare the graph for being long (owning) a stock vs. buying a call, one can see that we have limited the downside, while maintaining an unlimited upside potential, by buying a call.

CONS:  We are giving up the dividends that occur during the time period, and the call option has a time limit.  If we purchased the $10 call (symbol GEWCF) for $1.09 and the stock were to fall to $9.99 (a fall of $0.07) the call will expire worthless and we will lose $1.09 at expiration.

Do not be disappointed yet, remember, I am trying to explain the basics before I explain more complex combinations.

To be continued—

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