Joe Burrow Loves a Good Call Option
The next topic to understand is calls and puts. Calls and puts are the basis of all options trades. It is important to try and understand calls and puts to see how they will affect your game plan. Let’s start by taking a look at calls.
A call option is a contract between a buyer and a seller to purchase a stock at a certain price within a defined period of time. Per definition, the buyer of a call has the right, but not the obligation, to buy 100 shares of stock at a set price. On the flip, the seller of the call has the obligation, but not the right, to deliver the stock if exercised by the buyer.
Now how does this relate to the sports world? The best way to think about a call option is through financial incentives attached to contracts of players. Every year we hear of these crazy incentives that players can reach in order to make extra money. It is always a focus in the NFL. In week 18, ESPN always does a segment on players who are so close to reaching an incentive. Say Tom Brady needs one more touchdown to get an extra 5 million or Aaron Rodgers needs 500 more passing yards in order to get an extra 3 million.
Let’s take a look at how these incentives specifically relate to stocks and options. The best way to think about this is if Joe Burrow has a $1 million incentive in his contract to reach 5,000 passing yards. If Joe Burrow delivers 5,000 passing yards, he expects the Cincinnati Bengals to provide the $1 million. In this example, Joe Burrow is the buy side of the call option. He has the right, but not the obligation, to deliver 5,000 passing yards. If he doesn’t deliver, nothing happens other than missing out on $1 million dollars, no big deal. The Cincinnati Bengals are the sell side as they are expected to deliver if he does so. Similar to an options trade, with these incentives, there is a defined period of time in which the incentive can be reached. The Cincinnati Bengals will lay out a period of time he can reach this incentive, which is typically a season. So Joe Burrow has the right but not the obligation to get 5000 pass yards in a season and if he does then he will get financially rewarded.
When we think about a call option trade we can think of the Cincinnati Bengals and Joe Burrow example. For example, let’s say we have a bullish assumption on Apple and want to buy a call option in Apple (AAPL). In this case, we are Joe Burrow in the previous example. Like Joe Burrow, as a buyer of the option, we have the right, but not the obligation, to exercise the call and purchase stocks. For example, to put that bullish assumption to work we want to buy 1 contract of the 150 call option on the November 18th, 2022 expiration. As 5,000 was the strike price for Joe Burrow; 150 is the strike price for our call option in Apple. As the season end was the expiration date for Joe Burrow, November 18th is the expiration date for our option. To break down the specifics of the trade further, 1 contract gives 100 shares of the stock. So we now have the right to buy 100 Apple shares for $150 each up until November 18th. Now let's look at how that would trade today.
Apple stock closed at $142.45 today so let's say $142 to make life easy. As the holder of one contract of the 150 call option, we hope the stock rises above our strike price of $150 and beyond. Anything above $150 would represent a potential payout. Similar to Joe Burrow reaching anything above his strike price of 5,000 yards would represent a payout for him. In this example, Joe Burrow has a defined payout of $1 million for anything over 5,000 yards but for us, it is similar but a little different. In order for us to get a payout, we need the stock to be above our strike price of $150. Time passes and now we are seeing Apple trade for $155 as we get closer to our November 18th expiration. Let’s say we decide to exercise our call option at this point. Now, we can buy the 100 shares for $150 and we see a nice return of $500. In order to reach that return, we take the $155 it is currently trading at and subtract the $150 we bought our option at for a total of $5. Since we have one contract, which represents 100 shares, we take the 100 shares and multiply it by $5 appreciation to reach $500. A nice little payout.
However, with anything in life, the cost of doing business is not free. Let’s start with Joe Burrow. He enters into the contract with the Bengals and he has the $1 million incentive present but he is not just entering into this contract with the expectation that all he has to do is go out and throw the football around. He must attend team meetings, conduct promotional events for the Bengals, and more. Not to mention, the wear and tear he puts on his body by playing football. Similar to Joe Burrow, we must pay a premium to the seller. Think of this as similar to Joe Burrow appearing at events for the Bengals, we have to pay the seller of the option a premium of $1 per share so they will want to enter the transaction as well. In the end, we take the $1 of premium we paid per share and times it by the 1 contract we have, which represents 100 shares, to get a cost of $100 paid to the seller. When incorporating our cost, we now have a nice profit of $400, the $500 made in the stock going up to $155 minus the $100 in premium we paid to the seller. Who knew Joe Burrow and the Cincinnati Bengals could help us understand options trading?