The right to buy something for a set price for a predetermined finite period. IBM is trading at $130 at press time. And yeah, by the time you read this it will be some hugely different number but go with us on this one for now. I might pay $7 for the right to buy IBM for $150 in the next 5 months because I think their new cloud computing servers will generate huge profits and the stock will rock. That means that I am essentially paying $157 for IBM stock that is now trading at $130. Why on earth would I do that?
Greed. (It’s good again.)
Consider the math scenarios. If I buy 100 shares now, I will have spent $13,000 on IBM stock. If it goes to $180, I will have realized a 5 grand gain if I then sell. And if their cloud servers are not a hit and instead cloudy all day, the stock sinks back home on the range to $100 and my $13,000 has turned into $10,000. Sad face.
For the same $13,000 though, if I feel really spicy and aggressive and long, I could buy 13,000 / $7 or 1,857 call options (in practice, options are sold in buckets or contracts but for now think of it as one call for one share of stock). If the stock goes to $100 within the 5 months, I lose all of it. I also lose all of it if the stock is flat. And I also lose all of it if the stock only goes to $150. Forgetting commissions and taxes, if the stock goes to $153.50, I still lose half of the month I put in.
But if I’m right and the stock goes to $180, I’ve made $30 a share, less the $7 a share I paid for the options or $23 a share. I am exposed to 1,857 shares – and I made over 42 grand on the trade. Blows away the 5 grand in just owning the stock.