Call Option
call = Option TO BUY (call it back from the market). So, if the price goes up, but you still have the right to buy it at a lower price, then you have a valuable asset. You would have the right to buy the asset at a lower price, and to sell it today at the higher (market) price. If the market price exceeds the strike price, you are "in the money", and can sell the option for a profit. How profitable is the option? If the strike price is $100 and the asset goes up to $125 in the market, then the value of the option is $25, meaning that you could hold a contract that allows a person to purchase at $100 when the market is $125...so you make money. Note, however, that your option is worthless if the market price drops below the strike price.
Because the value of the put option rises as the underlying asset price rises (1:1 slope), you see the graph as a "hockey stick" shape (below).
Buying a call option - This is a graphical interpretation of the payoffs and profits generated by a call option as seen by the buyer. A higher stock price means a higher profit. Eventually, the price of the underlying security will be high enough to fully compensate for the price of the option.
On the other hand, if you had sold the call contract to someone else, then you would stand to loose money if the price of the underlying asset were to rise above the strike price. This would have a graph as a mirror image as follows:
Writing a call option - This is a graphical interpretation of the payoffs and profits generated by a call option as seen by the writer of the option. Profit is maximized when the strike price exceeds the price of the underlying security, because the option expires worthless and the writer keeps the premium
Foreign exchange Options
Gives you the right to purchase / sell a currency at a certain price (from now, up till an expiration date). You have the right to purchase (or sell), but you dont have to. On the other hand, the other party to this "options" contract is required to buy (or sell) if you ask them to. These "options" can be bought and sold in a market (much like the "futures" can).
- Examples: If you expect to make a payment in the next 3 months, then you might want to purchase a "call option", which will give you the right to buy foreign currency (for you to make your payment) at a specified price. This way, you will be protected if the currency FX rate suddenly changes. At least you will be able to purchase the foreign currency at that price, and to make your payment as needed.
- If, on the other hand, you are waiting for a foreign currency payment to arrive, and you are afraid that a sudden change in the FX rate might decrease the amount of money you will receive, you might want to purchase a "put option" which will give you the right to sell the foreign currency at a certain price (over the specified time period).
Call Options in general
A call option is a financial contract between two parties, the buyer and the seller of this type of option. Often it is simply labeled a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for (a) the premium (paid immediately) plus (b) retaining the opportunity to make a gain up to the strike price (see below for examples).
Call options are most profitable for the buyer when the underlying instrument is moving up, making the price of the underlying instrument closer to the strike price. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money".
The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.
Stocks and Bonds as Call options
The stock (equity) of a company can be thought of as a "call option" on the firm. The value of the call option increases with volatility, and a rise in volatility will increase the value of the stock of the firm. This means that the value of the stock equity will increase as the firm selects riskier projects. But, on the other hand, the value of the bond holders will decrease as riskier projects are selected. This can also be seen in terms of Options. The value of a risky bond can be seen as the difference between the value of the firm and the value of the call option on the firm. So, as the value of the call option increases (value of the stock increases), this means that the value of the bonds decreases. The bondholders are therefore hurt when the firm selects riskier projects.
Options & VC finance
The core of the NPV analysis assumes that you are sitting at time T=0, and that you have one decision to make.... You first calculate the expected cash flows, and then you discount them to the present value to compare NPV of the various choices. If the project has a positive NPV, you accept the project, if its negative you reject it.
The problem with this analysis is that it doesn't properly value Options. You often have the choice to invest more at a later date. You might have the option to invest just a little now...to get the project rolling, and then if its going well...then you invest a little bit more at a later date. This is the essence of the Venture Capital Method of Valuation. This is often referred to as a "decision tree" analysis which handles risk in a more sophisticated manner. With this method, you value the firm today assuming that future decisions will be optimal (even before knowing what those decisions are going to be).
Starting a project is like purchasing a call option. If further information is revealed that makes the investment seem attractive, then you have bought the right to that investment in the future. In general, it is in investors best interest to not exercise the call option immediately, but rather to wait until the end of the time period to see what new information is presented.
The problem with standard NPV analysis is that it does not consider the very real world flexibility that most managers (and Venture Capitalists) face. An NPV analysis might show that a project should not be undertaken, but thinking in terms of options, you might be willing to invest a little for the option of being there in the future. This explains alot of seed funding of a few million dollars of Silicon Valley companies (that no-one but Venture Capitalist's can figure out why they are being funded). Sometimes, its just a matter of believing in the vision of the entrepreneur, or the idea, or seeing potential for untapped market share, and a little VC money makes sense (if not in an NPV world). By allowing the investing firm to change its investment policy later according to new information, a seemingly unwarranted investment can be justified.
Managers that just use NPV are ignoring real-world flexibility in their analysis.
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 |
$13,000 |
+10% |
-10% |
| Call Option |
$540 |
+141% |
-100% |
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”.
http://luminouslogic.com/call-option-vs-long-position.htm
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