Looking at an example, imagine that hypothetical stock ABC is trading for $50/share. Now imagine that a hypothetical investor believes that stock ABC will rise above $70/share in the next six months.
This investor has several choices available to him/her. First, he/she could just buy the underlying stock and hold it. If the investor were to purchase 100 shares of ABC for $50/share, and the stock were to rise to $70/share, then the investor would make $2,000 on the investment ($7,000 - $5,000 = $2,000).
However, the investor might instead decide to purchase one call option with a strike price of $60/share that expires in six months. For the purposes of this example, let’s say that option cost $2.00. Now imagine that at expiration stock ABC is trading $70/share.
Considering that the underlying stock is trading for $70/share at expiration, that means the $60-strike call is now worth $10/contract. That means the investor has made $8 ($10 - $2 = $8) on each option contract traded.
So the initial cost of the option was $200 ($2 x 1 x 100 = $200). And the option is now worth $1,000 ($10 x 1 x 100 = $1,000), which means the investor has made a profit of $800 ($1,000 - $200 = $800).
On the day of expiration, the investor could either close the call position (i.e. sell the call) or exercise the call option. If the investor elects to exercise the call option, he/she would then own 100 shares of ABC with a cost basis of $60/share plus the premium paid for the option.
With ABC now trading $70/share, the investor could then choose to hold the underlying stock, or sell the underlying stock. If the investor were to sell the stock for $70/share the profit would be equal to $800.
That’s because the investor has a cost basis of $6,000 in the stock position ($60 x 100 = $6,000). And the proceeds from the stock sale would be $7,000 ($70 x 100 = $7,000). That equates to a profit of $1,000 ($7,000 - $6,000). However, one also needs to account for the cost of the option contract, which was $200 ($2 x 1 x100 = $200). That leaves the investor with a net profit of $800 ($1,000 - $200 = $800).
As one can see, the profit would be the same if the investor/trader had simply closed the option position by selling the call (i.e. closing the position).
One reason to exercise the call, and hold the stock, would be if an investor/trader believed the stock had further upside potential.
