Helen and Ivan are planning to celebrate their wedding anniversary next month in USA when Vaccinated Travel Lane (VTL) opens on 19 October. However, they are unable to purchase the tickets until 2 weeks later, because their vacation leaves have not been approved yet and their paychecks will only come in by month’s end.
However, Helen and Ivan are concerned that by 2 weeks’ time, the air ticket price would be inflated due to high demands from pent-up travelers from Singapore. They decide to use a small premium to buy an insurance plan offered by the airline company to secure the price ticket at the current price. That means that in 2 weeks’ time, even if the ticket price doubles, Helen and Ivan will still pay at the current price.
Using the above example, I will explain how a CALL option works.
The buyer of a CALL option (like Helen and Ivan) is concerned that the share price may rise by a lot in coming weeks and thus decides to buy some form of insurance to lock in the current share price for a period of time (say 2 weeks).
The seller of a CALL option, often someone who also owns the shares (like the airline who sells air tickets), is willing to sell at the locked-in price after 2 weeks. In return, he collects a premium for offering this insurance plan to the buyer.
There are a few scenarios that can happen.
Scenario 1: The air ticket price doubles (share price is higher than the locked-in agreed price)
Helen and Ivan would be like: “Heng Ahhhh (Luckily) we bought the price of the ticket at a lower price.”
The airline company, seller of the insurance on the other hand, would lose out on a huge profits as ticket price has doubled.
In the CALL option contract, the buyer can buy 100 shares from the seller at the agreed price, which is half of the market price since the share price has doubled. The seller of the CALL option is obliged to sell his shares at the agreed price, which may probably be a price he is comfortable to sell in the first place. But seeing that he could have earned significantly more may give him many sleepless nights.
Scenario 2: The air ticket price falls below the current (agreed) price in 2 weeks time, due to sudden surge in Covid-19 cases and the VTL with USA is halted.
Helen and Ivan would be like: “Oh no! There goes our premium”. The airline would have pocketed the premium without doing anything, as it does not make sense to sell the ticket at the agreed price when the market price is already lower than the agreed price.
In a CALL option contract, when the market price of the share drops below the strike price (agreed price) on expiration date, the contract is not exercised and the seller gets to keep the premium without having to lose any of his shares.
Scenario 3: Helen and Ivan or airline company can decide to close the insurance plan before the expiration date.
One week after purchasing the insurance plan from the airline company, Helen and Ivan realise that the ticket price is not increasing at all, which means the chance of losing their premium is increasing. They decide to exit the contract by selling away their insurance plan, i.e. they turn buyer to seller and earn some premium back so as to minimise their loss.
Similarly, if the airline company observes that the ticket price is increasing exponentially, it can choose to buy back the CALL option contract (same strike price and expiry date but this time round, they are buyer instead of seller) and close the contract so that they can earn a higher profits by selling their shares on the open market.
Scenario 4: The air ticket price doubled but Helen and Ivan decide to sell the insurance plan off instead to earn money and change their holiday destination to Bali.
As the ticket price doubled, the increase in the premium of the contract will be close to actual increase of price change. Helen and Ivan decide to sell away the insurance plan to earn a good profit due to the spike in ticket price.
In a CALL option contract, the buyer can also earn profit when the market price of a share rises and thus the option contract increases in value. He will turn from buyer to seller and earn the increase in premium price.
There is another strategy called LEAPS (Long-term equity anticipation securities ) whereby a buyer buys a long term CALL option and expects the share price to rise in value over time and then profit by selling away the CALL option. LEAPS can also happen for a PUT contract whereby the owner of the share wishes to hedge his shares against unfavourable conditions in the long run and protect the price that he can sell, just in case the stock plunges to $0.
I hope this light-hearted analogy helps you in understanding CALL opinion better and hopefully spark off your interest to want to learn more. Options trading is not a difficult concept to learn and with the various strategies, it is possible to minimise your loss and maximise your profits. Some view it as a lower risk than owning the stock itself because the maximum amount you can lose is your premium if things do not go your way, as compared to the loss you will incur if you were to buy 100 shares.
Lastly, for friends who are planning to travel like Helen and Ivan, I wish you bon voyage and enjoy your well-deserved holidays!
How PUT Option Works