For example, stock options are options for 100 shares of the underlying stock. Suppose a trader buys a call option contract on ABC shares with an exercise price of $25. He pays $150 for the option. On the expiry date of the option, ABC shares will be sold for $35. The purchaser/holder of the option exercises his right to purchase 100 shares of ABC at a price of $25 per share (the exercise price of the option). He immediately sells the shares at the current market price of $35 per share. He paid $2,500 for the 100 shares ($25 x 100) and sold the shares for $3,500 (35 x $100). His profit from the option is $1,000 ($3,500 to $2,500), less the $150 premium paid for the option. Thus, its net income excluding transaction costs is $850 ($1,000 to $150). That`s a very good return on investment (ROI) for only an investment of $150. One of the advantages of a vertical spread is that it reduces the break-even point of your strategy and eliminates the time drop (because even if the underlying share price remains the same, you will still reach the break-even point – not lost).
However, since the vertical spread usually bets that the price of the underlying security will remain within a certain range, it has limited profit potential, which may not be the best option if you are very bullish on a stock. The advantages of using an option in this strategy are that you can use minimal capital to trade many shares of a security instead of raising the capital to buy a particular stock. Here is an example that indicates the potential payment of a call option on rbc shares with an option premium of $10 and an exercise price of $100. In the example, the buyer incurs a loss of $10 if RBC`s share price does not exceed $100. Conversely, the caller is in the money as long as the share price remains below $100. You buy a call option with an exercise price of $115 for one month in the future for 37 cents per contact. Your total cash outflow is $37 for the position plus fees and commissions (0.37 x 100 = $37). For an appellate buyer, when the market price of the underlying stock moves in your favor, you can choose to “exercise” the call option or buy the underlying stock at the strike price. U.S. options allow the holder to exercise the option at any time until the expiry date.
European options can only be exercised on the expiry date. If the share price rises significantly, buying a call option offers much better profits than owning the stock. To make a net profit from the option, the stock must exceed the strike price to offset the premium paid to the call seller. In the example above, the call breaks even at $55 per share. Figure 2 below shows the payment of a hypothetical 3-month put option from RBC with an option premium of $10 and an exercise price of $90. The buyer`s potential loss is limited to the cost of the put option contract ($10). The buyer of a call option attempts to make a profit if the price of the underlying asset reaches a price higher than the exercise price of the option. On the other hand, the seller of the call option hopes that the price of the asset will fall or at least never increase as high as the exercise price of the option before it expires, in which case the money received for the sale of the option is a pure profit. If the price of the underlying security does not exceed the strike price before it expires, it is not profitable for the option buyer to exercise the option and the option expires worthless or “out of money”. The buyer suffers a loss equal to the price paid for the call option. Alternatively, if the price of the underlying security exceeds the source price of the option, the buyer can exercise the option profitably.
The break-even point – at which the option starts making money, having intrinsic value or being in the money – is $55 per share. This is the strike price of $50 plus the cost of $5 for the call. If the stock is trading between $50 and $55, the buyer would amortize some of the initial investment, but the option shows no net profit. .