Image via WikipediaExample of a call option on a stock
Buy a call: The buyer expects that the price may go up.
The buyer pays a premium that he will never get back.
He has the right to exercise the option at the strike price.
Write a call: The writer receives the premium.
If the buyer decides to exercise the option, then
the writer has to sell the stock at the strike price.
If the buyer does not exercise the option, then
the writer profits the premium.
'Trader A' (Call Buyer) purchases a Call contract to buy 100 shares of XYZ Corp from 'Trader B' (Call Writer) at $50/share. The current price is $45/share, and 'Trader A' pays a premium of $5/share. If the share price of XYZ stock rises to $60/share right before expiration, then 'Trader A' can exercise the call by buying 100 shares for $5,000 from 'Trader B' and sell them at $6,000 in the stock market.
Trader A's total earnings (S) can be calculated at $500.
Sale of 100 stock at $60 = $6,000 (P)
Amount paid to 'Trader B' for the 100 stock bought at strike price of $50 = $5,000 (Q)
Call Option premium paid to Trader B for buying the contract of 100 shares @ $5/share, excluding commissions = $500 (R)
If, however, the price of XYZ drops to $40/share below the strike price, then 'Trader A' would not exercise the option. (Why buy a stock from 'Trader B' at 50, the strike price, when it can be bought at $40 in the stock market?) Trader A's option would be worthless and the whole investment, the fee (premium) for the option contract, $500 (5/share, 100 shares per contract). Trader A's total loss is limited to the cost of the call premium plus the sales commission to buy it.
Related blog post: Put Options.