Eli5: How do stock calls work?
In: 3
Sometimes I think analogies in other industries are better at explaining, so instead of a stock let’s visit Bill the farmer.
Meet Bill, a friendly farmer who raises sheep on his farm. One sunny day in January, Bill starts thinking ahead and realizes that during the busy Christmas season, people love to enjoy delicious lamb dishes. He knows that the demand for sheep will be high, and he wants to make the most of it.
On the other side of town, we have Jane, a talented restauranteur who owns a popular restaurant that gets incredibly busy during the Christmas season. Jane knows that her customers adore her special lamb recipes, and she wants to ensure a steady supply of sheep for her restaurant during that festive time.
Bill and Jane decide to strike a deal that benefits them both. They enter into an agreement called a call option, which gives Jane the right to buy sheep from Bill at a fixed price at a later date.
They agree on an option price of $10 per sheep. Jane pays this amount upfront to secure her right to purchase the sheep for $100 in the future. This option price acts like a reservation fee for Jane, ensuring that she can buy the sheep at a predetermined price when December 15th arrives.
Now, let’s explore the potential profits based on the price of sheep at maturity, which is December 15th.
Suppose the market price of sheep on December 15th is $120 per sheep. Jane exercises her call option and buys the sheep from Bill at the predetermined price of $100. She can then use the sheep in her restaurant and enjoy a profit of $10 per sheep ($120 market price – ($100 sheep price + $10 option price)).
On the other hand, if the market price of sheep drops to $80 per sheep by December 15th, Jane decides not to exercise her call option. It wouldn’t make sense for her to buy the sheep at $100 when she can acquire them at a lower price from the market. In this case, she lets the option expire, losing the $10 option price but avoiding the additional expense of buying the sheep at a higher price.
For Bill, he receives the $10 option price regardless of the sheep’s market price on December 15th. If Jane exercises her option, Bill sells the sheep to her at the predetermined price of $100 making a total of $110 per sheep. If the price is $80 and Jane doesn’t exercise her option, Bill is free to sell his sheep on the open market, earning a total of $90.
By utilizing call options, Bill and Jane mitigate risks and uncertainties associated with price fluctuations. They lock in a predetermined price, providing stability and enabling them to plan for the busy Christmas season.
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