Alice is getting into the world of investing and she has her eyes on the company XYZ. The current stock price of that company is $20 but Alice is almost certain that in a few months the stock price will rise to $28 or more so she wants to get in on the action. The problem is that Alice is short on cash, she only has $200 to spare and with that money she could only buy 10 shares. Even if the stock rises to $28 and she sells her 10 shares at that price she will only make a net profit of $80 (10 x $28 – 10 x $20). That’s clearly not enough for her, she wants to find another way to make a bigger profit with her certainty that the stock will soon increase in value.
Alice tells her dilemma to her friend Bob who’s also interested in investing and who actually owns 100 shares of XYZ. Bob likes the stock but he doesn’t believe that it will get to $28 any time soon. In fact, he’s willing to bet on it.
Bob: “I think I have a solution for you Alice. What if we bet on the future price of the stock?”
Alice: “How would the bet look like?”
Bob: “I have 100 shares of XYZ right now and I bet you that it will never get to $28 within the next 4 months. If it does I will give you the option of buying my 100 shares at the current price of $20 so you could make a profit of $8 per share for a profit of $800”
Alice: “What if the stock price goes beyond $28 per share?”
Bob: “You are not forced to buy my shares as soon as it hits the target price of $28. Is up to you to decide when, within the 4 months period, you want to exercise the option to buy my shares at the original price. If for example the stock goes to $30 then you’ll have a profit of $10 per share for a total of $1000 in gains. But that option is only available if the stock hits or go above the target price of $28”
Alice: “That sounds too good to be true, what’s the catch?”
Bob: “The catch is that you have to pay me $200 to enter the bet and no matter who wins I get to keep that money. Even if the stock goes up to $27 but it never quite hits the $28 mark before the expiration date I get to keep that money and my shares of course”
Alice: “Let me see if I understood. If within the 4 months the price gets to $28 and I decide to exercise the option at that point I will make $800 but because I’m paying $200 to enter the bet, my net profit would be $600. Is that right?”
Bob: “That’s right”
Alice: “But if I lose the bet, I’ll lose $200, even if the share price goes to $27.99, right?”
Bob: “Yes”
Alice: “I like those odds. The problem is, I don’t have $2000 to buy your 100 shares at $20 each in case I win, I’m short on cash right now”
Bob: “Not a problem, if you win, I’ll pay you what’s owed. I can always sell those shares in the open market and raise money to honor our bet”
Alice: “It’s on then!”
Let’s reflect on Alice’s options. With $200 she could buy 10 shares at the current price of $20 and if the stock increases to $28 and she decides to sell at that point, she will be looking at an $80 net profit. On the other hand, if she takes Bob’s bet, pays $200 to enter the bet and wait until the stock hits $28 to exercise the option she will have a net profit of $600. What a sweet deal!
Unfortunately the scenario described above doesn’t paint the full picture. In the table below we can compare multiple scenarios to better understand the pros and cons of entering Bob’s bet vs just buying the stocks directly. For all scenarios we are going to assume a starting capital of $200 and a starting stock price of $20 per share.
| Scenario | Stocks profit | Bob’s bet profit |
| The stock goes up to $28 | $80 | $600 |
| Stock goes up to $50 | $300 | $2800 |
| Stock goes up to $27.99 | $79.9 | -$200 |
| Stock goes down to $18 | -$20 | -$200 |
Notice how with the same $200 of initial capital Alice can substantially boost her profits by entering Bob’s bet as long as the stock price rises to or goes beyond the agreed upon target price of $28. That’s called leverage. On the flip side, the probability of losing money also increases as a failure to reach the target price will trigger the loss of the totality of the initial investment. The figure below provides a better way to compare both approaches.
Betting on the future price of a stock is called options trading. In particular, betting that a stock will increase in price over time is a call option. Because Bob was the one who put his shares on the line for the bet he’s considered a market maker and what he did creating a bet of the stock price going up is referred as “to write a covered call option“. The agreed upon price of $28 to trigger the option is known as the strike price and the $200 that Alice has to pay Bob to enter the bet is called the premium.
If there’s a takeaway from this article is that call options magnify potential profits while increasing the probability of a loss that at least is limited (capped) to the value of the premium.
In the next article we will discuss another type of derivative, the put options.