Let’s say that a trader is bullish on silver short term, so he wants to trade 1000 shares of SLV. Instead of buying 1000 shares of SLV, the trader buys 10 Febuary SLV Call Options that expire in about 6 weeks.
A Call Option locks in a pre-set buy price for an asset. Buy buying Call Options on SLV, the trader is locking in a pre-set buy price. If the price of SLV should rise above the locked in buy price, the trader can use his option to buy SLV at the price he locked in, sell it for the current higher price, and make the difference in profit.
Let’s look at some of his choices for the Febuary call option contracts.
The $19.50 Strike costs 62 cents up front. This contract locks in a pre-set buy price of $19.50 for SLV over the next 6 weeks. SLV is currently $19.42, so this option is out of the money. In other words, it has no Intrinsic Value. The value comes only from the fact that the price of SLV moves, in other words, he volatility, and that there is time for SLV to possibly move above $19.50.
If the price of SLV moves above $19.50, this option begins to have Intrinsic Value. However, if the trader chooses to buy this contract, for the trade to be profitable, the price of SLV has to move to $20.12 to cover the cost of the buying the option contract.
Let’s say the price of SLV climbs to $20.12 or above. The trader uses his options to buy the SLV at $19.50. He then sells it at the current price of $20.12 or above. He paid $19.50 for SLV and he paid 62 cents up front to buy the options, so his total cost is $20.12 a share. If he sells SLV above $20.12, the difference is his profit.
For instance, let’s say that SLV climbs to $21.00. The trader uses his options to buy SLV at $19.50, and immediately sell it for $21.00. Therefore he made $1.50 a share. However, his up front cost was 62 cents a share. So his net profit is $1.50 minus 62 cents for a profit of 88 cents.
It is important to note here that in most cases, the trader would not use his option to actually purchase and sell SLV. In most cases, the trader would simply re-sell the option for the profit instead.
If the price of SLV climbs above $20.12 within the next 7 weeks, the trader makes a profit.
If the price of SLV climbs above $19.50, but not up to $20.12, the trader loses money. The price of SLV is above the $19.50 Strike Price, so the trader does sell his option, but the price he gets for selling it is less than the original 62 cents he paid up front. In other words, time ran out faster than price moved.
If the price of SLV stays below $19.50, the option expires unused, and the trader loses the 62 cents he paid up front to buy the Call.
So let’s re-cap. The price of SLV is $19.42 and the trader feels the price of SLV will rise within the next few weeks. Therefore he buys 10 SLV Call Options that expire in 6 weeks. The options lock in the right to buy SLV for $19.50.
This means that, for the trade to be profitable , within the next 6 weeks, the price of SLV needs to climb not just above the Strike price, but far enough above the Strike Price that the difference the trader makes in profit is enough to cover the original up front cost to buy the option contract.
The $19.50 Call was not the trader’s only choice. Other Strike Prices that expire the same month, with the difference in up front costs, in other words, the amount the trader must risk, versus how much SLV has to increase for the trade to be profitable.