Purchase of a Call Option
Frank feels good about the prospects for ABC Inc., the company's shares have a current market value
of $29.00. ABC Inc. is in pharmaceutical research & development and it is rumored to be on the brink
of a significant discovery; however, the results from the clinical trial phase are still not available.
Frank decides to buy a June 35 American style call for 300 shares of ABC Inc. with a cash-settlement
provision and pays $1.00 per share for the option. The cash-settlement provision simply means that
should the option be exercised, the difference between the MV and the option strike price will be settled
in cash by the writer of the option as opposed to the transfer of the underlying security to the option
buyer.
After he purchased the call option, the shares continued to increase in value to $36.50 and Frank
exercised is call option but did not purchase any of the underlying shares. Soon thereafter, however,
the share price quickly fell to $21.00 after the disappointing results from the clinical trials were released.
In this instance, compare Frank's return through the use of a call option as opposed to the actual
purchase of the shares.
