Let’s imagine that I have a tractor I am offering for sale for $20,000—which is a smoking deal because the same tractor is selling elsewhere for $25,000. My neighbor realizes that I am unaware of the fair market price and concludes that my tractor would be a good investment for him. What’s more, he has come into an inheritance—but he has to wait 6 months to get the money while the courts probate the will. Because he doesn’t want to lose this auspicious opportunity, he asks if I would sell him a call option.
A call option is just a fancy term for a contract related to selling an asset in the future. My neighbor offers me $1,000 to take the tractor off the market and store it until he is ready to buy it in 6 months. This $1,000 does not apply to the cost of the tractor—he still has to pay me $20,000 at the time of the sale. If he does not keep his end of the bargain I can keep the $1,000 and sell the tractor to someone else.
Call Options Carry Risk
After selling the call option I might discover that my tractor is really worth $25,000. Worse, perhaps demand goes up and 6 months from now my tractor is worth $30,000. Because I sold my neighbor the call option I am contractually obligated to hold onto the tractor and sell it to him for $20,000—and he could turn around and sell the tractor to someone else for $9,000 profit.
But that scenario is not the only possible outcome. The tractor could lose value over those 6 months. Maybe a serious defect is discovered in this model and as a result the tractor’s market value drops to $15,000. My neighbor might decide not to buy the tractor from me either because he can buy it from someone else for $15,000 rather than the $20,000 he agreed to pay me—or because he prefers a tractor that is not prone to blowing up. In either case I keep the $1,000 and the tractor but lose the $5,000 extra I would have made if I had sold the tractor outright 6 months earlier even though it was underpriced at $20,000.
Call options can be used with any asset—tractors, stocks, real estate. The key is that both parties assume the potential for risk and reward. If the price of the underlying asset moves up or down while the call option is in effect one side will lose money. The buyer of the call option can tie up an asset by spending only a fraction of the asset’s value to do so.
Want to Know More?
The following links are good resources for learning more about call options:
Related Topics: call options