How is it possible to buy call options with a strike price below current market price?

Question

I'm a newbie with all of this. I've been reading on call options and from my understanding, you're paying some "premium" to buy an "option" to buy the stock at a certain fixed price. Is this right?

So how come we can buy options on robin hood where the break even point is lower than the market price? Isn't that just free money? I don't understand.

For example, I just bought an after-hours call for PLTR at $0.37 per share for a total of $37 with a break even price at $8.37. PLTR was already at like $8.75-9.00. Will robinhood still execute my order in the morning?

I also noticed that there are many options you can buy where the strike is less than the market value. So how exactly does this makes sense? I mean, we can't all be getting "free money" can we?

Answer 1

You didn't buy anything. You placed an order to buy. If it's a market order, you'll pay whatever the going price of the option is in the morning. If it's a limit order, you'll get nothing.

Option premium has two components. For a call, if the stock's price is higher than the strike price, the difference is the intrinsic value. If the call's premium is more than that, the difference is extrinsic or time value.

For example, if XYZ is $9.00 and a $8 call is $1.50, it's $1 of intrinsic value and 50 cents of time value. If you buy the call, the cost of acquiring the stock via exercise will be $9.50 .

There is no free money here.

Answer 2

I can't speak for sure on the after hours order, but more than likely the cost for those options (and thus your break-even price) will go way up when they are actually executed (whether you actually buy them will depend on whether placed a market order or a limit order of some sort). My guess is you placed a market order and will pay much more than 0.37 per share.

As for how you can buy calls with a strike below the current market, the answer is that the premium for those options will be more than the difference between the strike and spot price, so you're paying extra for the protection of paying a minimum price for the stock.

For example, PLTR is around 8.89 after hours right now. You can buy a call with a strike of 8.00 and if PLTR stayed at 8.89 until the option expires, you can buy it for 8.00, earning a 0.89 per share profit. But the option is going to cost you more than 0.89, so a new profit is not guaranteed. The price of the stock will have to be above the break-even price (the strike plus the premium) for you to make a profit. But you're guaranteed to pay at most 8.00 for the stock - if the stock is below 8, you would not exercise the option, since you could buy the stock for less on the open market.