Note: Please read the disclaimer. The author is not providing professional investing advice.
Burton Malkiel has a nice introductory example of how call options work on page 36 of the latest release of his classic, A Random Walk Down Wall Street
He uses the price of tulip bulbs in 17th century Holland for his example but I thought I’d repeat it using the current price of Apple Inc. stock and options.
Today, August 1st, AAPL is trading at about $130 per share. What should I do if I feel that by mid-August it’ll be trading significantly higher?
Long Position
I could take a long position by simply buying, say, 100 shares of AAPL at $130 per share. Hopefully the price of the stock will rise and I’ll later sell those shares and pocket the difference.
Call Option
But instead of actually buying shares today, I could instead pay a lower $5.40 per share to buy the option to later buy 100 shares of AAPL at $130. Assuming the stock does go up, I’ll exercise my option to buy at $130, immediately sell at whatever the market is paying, and pocket the difference. The only catch is, my option is only valid for about 17 days.
An Example
Let’s examine what happens with both investment vehicles if the price of AAPL swings either up or down 10% or $13.
Long Position
Buy 100 shares at $130 per share. (pay out $13,000)
Sell if price rises to $143 per share. (receive $14,300)
Return on Investment (ROI) = ($14,300 / $13,000 – 1) x 100% = 10%
…and vice versa for 10% loss…
Call Option
Buy for $5.40 per share option to later buy 100 shares at $130 per share. (pay out $540)
Buy & Sell if price rises to $143 per share. (receive $1,300)
ROI = ($1300 / $540 – 1) x 100% = 141%
…and if stock instead drops 10%, lose all of the $540…
Let’s put it all in a table…
| Investment Type |
Initial Investment |
ROI if AAPL ↑ $13 / share |
ROI if AAPL ↓ $13 / share |
|---|---|---|---|
| Long Position | |||
| Call Option |
Let’s also summarize some benefits and drawbacks of each investment vehicle.
| Long Position | Call Option |
|---|---|
| Larger investment – more money at risk | Smaller investment – less money at risk |
| Will receive dividends | Will not receive dividends |
| If price goes up significantly, smaller % return on investment | If price goes up significantly, larger % return on investment |
| If price stays same, no money lost – can hold indefinitely | If price stays same, lose all of initial investment – option has expiration date |
| If price goes down, can still hold position in hopes of price rising later – can hold indefinitely | If price goes down, lose all of initial investment – option has expiration date |
As Malkiel writes, with the call option it is “…possible to play the market with a much smaller stake as well as to get more action out of any money invested”.
true but true investors believe in long run…