Options as Investments
The owner of a call option has paid a dollar or so for the right to buy 100 shares of XYZ corporation’s stock (currently selling at $100/share) from the owner who sold the call option for $102/share at any time within a specified period, such as a year. The buyer knows that in most years the price of XYZ rises at least this much even though it sometimes loses, so doing this over and over again captures long-term price patterns. Now, imagine that the price rises to $105. That call contract could be exercised to buy 100 shares at $102 (a $3/share profit), or it can be sold to someone else for (almost) $105. Selling the call contract is what many investors do, harvesting almost $300 per 100-share contract. The seller of the call would have preferred to have kept all of the $5 gain, but at least the seller locked in $2 of that from the call premium. If the stock failed to rise above the strike price of $102 (or the stock lost value), the call would not be exercised; in that case, the premium would be the most the buyer lost even if the stock price plummeted, and the seller at least got that premium, mitigating some of that stock owner’s downside risk….