What is an Option?
There are two types of options. Call options allow investors to position for upward movement in underlying share prices. An option contract has an expiration date and a strike price. The price a trader pays for an option is called a PREMIUM. The buyer of the call option has the right to purchase the stock at the strike price at any time before the expiration time.
Let’s assume that an option at the $170 strike and one month to expiration costs $3.50 per contract. Since the contract is for the right to buy 100 shares at $170, it will cost $350. If the stock rises to $200, you make $400 profit on the investment of $1,600. In case of the option 100*(200-170)-350= $2,650 profit.
The investor is bullish, but thinks that the share price might not reach $170, and is unlikely to go above $180 before expiration. But the investor could SELL a call option at a higher strike.
Let’s say he sells a call option at the 180-strike and this time receives a premium of $1.10. Since the option contract covers 100 shares, he receives $110. By ‘spreading’ across the 170/180 strike prices he can reduce the cost of the trade and would face a lower maximum loss of $240 in the event shares failed to reach $170 by expiration ($350-$110=$240). However, by selling the 180 call the investor reduces the maximum possible loss to $240 and still could have a total profit, up to $760 that is the maximum. All profits above $180 on the stock are foregone.
