The basic problem is that the stock would have to move up in price above the strike price before the option expires because the option is worth nothing at expiration.
Intrinsic value of call option = Market Price of the Stock - Strike Price
The option premium price fluctuates depending on two factors:( a) the underlying price of the stock, and (b) the time left until the expiration of the option.
- Buying and selling the stock, in scenario 1, results in a 20% return.
- This is not to be sneezed at, but compared to buying and selling the option in scenario 2, buying and selling the stock comes in as a poor second to a return of 1350%.
- Comparatively, scenario 3, buying and exercising the option, produces the smallest return of 18.3%.
- Moreover, this scenario 3 also requires the largest outlay of capital ($3,550 versus only $50 for the call option and $3,500 to buy the stock).
- However, if the stock price declines to $30 per share, buying the stock at $35 and selling it at $30 results in a $500 loss and a 14.28% loss (= -500/3500)
- Buying the stock option and having it expire results in a 100% loss on invested capital and a $50 loss of capital.
- There is no third alternative; the strike price is above the current price, so the option would not be exercised. The maximum loss is the cost of the option, $50.
- Buying and selling the option not only gives the greatest return on investment but also requires the lowest capital outlay.
- By buying a call option instead of the stock, the investor invests a small fraction of the cost of the stock.
- If the stock price rises significantly above the strike price within the period before expiration, the investor can profit by selling or exercising the option.
- In the later case, the investor can then sell the stock or hold it for long-term capital appreciation.
- The most an investor can lose from buying a call option is the cost of the option.
- Thus, the downside risk is limited, as opposed to the potential loss in the case of buying the stock.
- There are many examples of high-flying stocks that have risen to abnormally high prices only to fall back into oblivion, resulting in tremendous losses for those investors who had invested when the stocks were trading at excessively high price.