Call Option Payoff: Stock Price Above Strike Price

Imagine you’re thinking about buying a new gadget, perhaps the latest smartphone. You’re not sure if you want to commit to buying it right now, maybe you’re waiting for a price drop or want to see more reviews. But, you also don’t want to miss out if the price goes up or it becomes hard to find. A call option is a bit like getting a reservation to buy that smartphone at a set price, regardless of what happens to the actual price later.

Let’s break it down. When you buy a call option, you’re essentially buying the right, but not the obligation, to purchase a specific stock at a predetermined price, called the strike price, on or before a certain date, the expiration date. Think of the strike price as the reserved price for your smartphone. The expiration date is like the deadline for your reservation.

You pay a small upfront cost for this right, which is called the premium. This premium is like the fee you might pay for making that reservation. It’s your initial investment in this potential opportunity.

Now, let’s consider what happens when the expiration date arrives, and we’re specifically interested in the scenario where the stock price is above the strike price. This is the exciting part for a call option holder.

If, on the expiration date, the actual price of the stock in the market is higher than your strike price, your ‘reservation’ to buy at the lower strike price becomes valuable. Think about our smartphone example. If the smartphone is now selling for much more than the price you reserved it at, your reservation is worth something.

So, how do you calculate the final payoff? It’s quite straightforward. If the stock price at expiration is, say, 150 dollars per share, and your strike price is 140 dollars per share, your call option is ‘in the money’. This means it’s profitable for you to exercise your option. To exercise your option means to use your right to buy the stock at the strike price.

In this situation, you would effectively buy the stock at 140 dollars using your option, and you could immediately turn around and sell it in the market for 150 dollars. The difference, 150 dollars minus 140 dollars, which is 10 dollars per share, is your gross profit before considering the premium you initially paid.

Therefore, the payoff from a long call option, when the stock price at expiration is above the strike price, is calculated by subtracting the strike price from the stock price at expiration. This difference represents the intrinsic value of the option at expiration. This is the amount of money you would make per share if you exercised the option and immediately sold the stock at the market price.

However, remember that initial premium you paid to buy the call option in the first place? To determine your net profit, you need to subtract the premium from this payoff. For example, if you paid a premium of 2 dollars per share for the call option in our smartphone scenario, your net profit would be 10 dollars payoff minus 2 dollars premium, resulting in an 8 dollars net profit per share.

If the stock price at expiration is at or below the strike price, the call option expires worthless. You wouldn’t exercise your right to buy the stock at a price higher or equal to what you could get in the open market. In that case, your loss is limited to the premium you initially paid.

In summary, when you hold a long call option and the stock price ends up being higher than the strike price at expiration, your payoff is determined by the difference between the stock price at expiration and the strike price. This difference represents the profit you can make by exercising your option to buy at the lower strike price and selling at the higher market price. Remember to always factor in the initial premium you paid to find your true net profit or loss. Call options offer a way to potentially profit from stock price increases while limiting your initial risk to the premium paid.