Call option for IBM stock with expiration
date 3 months from now and strike price of $100:
The option gives you the right to buy this
stock 3 months later at a fixed price of $100 - independent
of its market value. The main point is that - as
the name suggests! - this is purely optional, you don't have
to buy the stock. So, clearly, if after 3 months the IBM stock is at $110
you exercise the option and buy the stock for $100
as you can immediately sell it again at the current market value and keep
the $10 difference. If the market value is less
than $100 you just trash your option.
this discussion neglects transaction costs that have to be taken
into account, too. Buying and selling stocks costs some money.
The payoff for this
call option can be checked out in the
pop-up window. Just choose
the strike price and you will see the amount of money you get out of the option
depending on the value of the stock at the expiration
Up to now we have - erroneously
- assumed that those options are for free. Therefore we could never lose money.
But - the option has a price that has - initially-
to be paid to the institution that issues this option. However, the price of
options varies all the time, so an option - like a stock - is traded on the
financial markets. For estimating the payoff we can enter an option price
in the window and recalculate the payoff, go ahead and try it yourself!