Here’s a real example of how a call option works.
NAB’s share price at 24 May 2009 was $22.
- You could buy a June call option with an exercise (or “strike”) price of $22, for 52c.
- Because Australian options contracts are sold in lots of 1000 shares, the price of your options would be $520 (52c x 1000), plus your trading (broker) costs of about $40 per trade, so a total cost of $560.
How you could win
- Assume the share price moves to $23 by the end of June. If you waited until then, you’d have the right to exercise your call option, buying NAB shares for $22.
- Because the shares are now worth $23, you can sell them and pocket a profit of $1 per share. Or, as is more common, you could sell your call options for a higher price than you originally paid for them, giving you a similar profit.
- After you subtract your costs (remember the call option cost 52c per share) you’d be left with a profit of 48c per share. Your overall profit, after subtracting the cost of trading ($80 for two trades in this case) would be $400, or 71% of your original investment.
So how does this compare with investing the same amount ($520) in NAB shares instead? In that case, you would have purchased 23 NAB shares. If the price rose by $1 and you sold the shares, your profit would be $1 per share, or $23. This wouldn’t even cover your brokerage fees, so in this example, with the same original investment ($520), options would be far more profitable than shares.
How you could lose
- If you bought a $22 call option for NAB shares, and the share price dropped to $21 by the end of June (and assuming you didn’t cut your losses and sell the option before then – a “stop loss”), your option would be worthless. There’d be no point exercising your right to buy the NAB shares for $22 and your loss would be what you paid for the call option and the brokerage fee – $560 in total.
- In this case, it would have been better to have invested your money in the shares, which would still be worth $21 each, just 5% less than what you paid for them.
- You could also have benefited by buying a put option, instead of a call. A put gives you the right to sell shares – in this example, for $23, which is $1 higher than the eventual share price.