How to Determine the Price to Pay for a Call Option
Original post by Mike Parker of Demand Media
Equity securities represent ownership in the underlying assets. Common stock is a widely held type of equity security. Stock ownership provides the benefit of unlimited potential growth as the value of the stock increases, but it also involves the risk of substantial loss if the stock decreases in price. An investor can participate in the stock growth while limiting his potential loss by investing in call options. A call option is an investment that provides control over the underlying security but not ownership. The price of a call option is a factor of both its time value and intrinsic value.
Determine the current price of the underlying stock. One stock option typically controls 100 shares of the underlying stock. If the price of the underlying stock is above the exercise price, or strike price, of the call option, the option is said to be in the money. A call option that is in the money will have an intrinsic value equal to the difference between the strike price of the option and the current price of the stock. If the price of the underlying stock is equal to or below the strike price, the call option has no intrinsic value.
Determine how much time remains before the call option expires. Call options are typically issued with quarterly expiration dates, so an underlying security may have multiple stock options available with varying expiration dates. The amount of time remaining before the call option expires is referred to as its time value. A call option with a longer expiration date will have greater time value than a call option on the same underlying security with a shorter expiration date.
Consider time decay. Time decay refers to the tendency of the time value of the call option to decrease more rapidly as the option nears its expiration date. A call option that is in the money as it nears its expiration date will have little time value, and it will trade very close to its intrinsic value. A call option that is out of the money or at the money may have no time value at all. You may be able to purchase such an option for a very small premium, but you may not be able to sell it.
Consider the volatility of the underlying security. The time value of call options may increase based on the volatility, or propensity of the price of the underlying security to move up or down. A call option on a stock that has a historically narrow trading range will likely not have a great deal of fluctuation in price, because there is little historical evidence that the price of the underlying stock will fluctuate. A call option on a stock that historically has wide swings in price is more likely to create a profit or loss for the options trader. This volatility of the underlying stock price creates greater profit potential and results in a greater premium in the price of the call option.
Determine the strike price and the expiration date of the option you wish to purchase. Determine the current price at which the option is being offered. Keep in mind that options are traded in a double-auction market, with both a bid and an ask price, much like stocks. You can enter many of the same types of orders with your broker that you would enter to buy stocks. If you are satisfied with the market price of the call option you can enter a market order, which will execute at the price the market determines. You may enter a limit-day order for a price below the current market ask price. If a seller is willing to sell at that price, the trade will be made. If not, the order will expire at the end of the day. You can enter a limit order on a Good Til Canceled basis, which remains open until it is filled or you decide to cancel it.
Tips & Warnings
- A wide spread between the bid and ask prices may indicate a limited market for the option. Some options traders will try to split the difference between the two prices to stimulate a trade.
- Call options only grant you the right to purchase the underlying stock. They do not convey ownership. If you allow your option to expire without either selling the option or exercising the option, it becomes worthless and ceases to exist.
- Investment brokerage account
- Access to current market information
- The Options Industry Council: Understanding Equity Options (pdf)
- The Options Industry Council: Equity Options Strategy Guide (pdf)
About the Author
Mike Parker has been writing professionally for more than 15 years. His work has appeared in various print and online publications, including "Grassroots Music Magazine," "Christian Single Magazine," BuddyHollywood.com and Lifeway.com. He earned a Bachelor of Arts degree in bible from Hardin-Simmons University.
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