Long
Call |
...or
Long Calls |
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Opinion:
Bullish to very bullish |
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| Description: | |||||||||||||||||||||||||||||||||||||
| Call buying is a strategy used if the investor thinks that XYZ will advance in price. It is important, given the risk, that the investor have a clear idea about where the stock is going and when. Simply thinking XYZ is a “great company that is sure to go up” is not enough. A Call purchase based on such vague notions is likely to cause frustration as losses mount when the advance fails to materialize. | |||||||||||||||||||||||||||||||||||||
| Call buying is the simplest form of option investment, and therefore,
is the most popular option strategy.
The success of this strategy depends primarily on the investor’s ability to: 1) select a stock that will advance in price, 2) select an expiration month that insures the expected advance will occur before the option expires, and 3) select a strike price so that the potential benefits of the advance are balanced with the possibility of losing the entire premium paid. |
Buying Calls: Why?
For the most part, there are two types of Call buyers:
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| The Speculator:
The speculative Call buyer uses options for their leverage.
For example, by buying a Call, the investor gains the upside potential of 100 shares of XYZ while at the same time investing a much smaller amount of the captal than required to buy 100 shares of XYZ stock. 100 Shares XYZ * $60 = $6,000.00 vs. 1 Oct 60 Call @ 4 7/8 = $487.50 This lower capital commitment allows the investor to do two things: 1) Potentially realize large % gains from a modest advance in XYZ. Note of caution: With a $4 advance in XYZ, a Call might climb to 4 1/2 from its purchase price of 3 (a 50% gain). But, leverage is a “double-edged sword.” A decline in XYZ can result in large % losses (up to 100%). Thus, the cost for more reward is more risk! 2) The other benefit of a lower capital commitment is QUANTITY – the ability to buy more Calls, thereby “controlling” more XYZ stock! Important note of caution: Buying more Calls because they cost less than buying shares of stock is a dangerous way to trade options. The profits will be greater of right, but the investor can lose most, if not all, of the initial investment if XYZ does not advance beyond the break-even point. |
| The Call-buying Stock Investor:
Some investors purchase Call options in lieu of buying stock.
For example, an investor who is ready to buy 500 shares of XYZ at $60 – but instead spends @2 437.50 for 5 ATM XYZ Calls – is not speculating. An investment decision is being made to use Call options instead of putting $30,000 of investment capital at risk. 500 Shares XYZ * $60 = $30,000.00 or 5 Oct 60 Call @ 4 7/8 = $2 437.50 By definition, a Call option gives the owner the right to buy XYZ at the strike price up until the option’s expiration. Therefore, by purchasing Call options, the investor is able to:
The Call buyer’s loss is limited to the premium paid for the Call option, while the stock buyer’s entire investment is very much at risk! Thus, the premium spent on the Call option can be viewed as the price that must be paid to insure a limited loss of capital in the event that XYZ declines instead of rallying. The Call’s time value is the cost of the insurance policy. The buyer accepts the trade-off: less reward ix XYZ rallies for less risk if XYZ declines. The Call buyer understands that the writer of a Call option is saying, in effect, to the buyer, “If, for the next 103 days until October expiration you don’t want to lose money from a direct investment in XYZ should it go down, and still participate if it goes up, you are going to have to compensate me for assuming this risk instead of you.” |
The Bottom Line:
Call buying offers the bullish investor two advantages:
However, selecting the right strike price on the right stock at the right time is critical for the Call-buying investor. The biggest difference between the “speculative” and the “insurance” Call buyer is in the answer to the question, “How many Calls do I buy?” Remember, the Call buyer who is buying Calls in lieu of a much larger
investment in the actual stock of XYZ is substituting the shares represented
by the Call options for the actual XYZ shares he or she wants to buy.
Thus, the investor buys one Call for each 100 shares, no matter which
strike price is selected for purchase. |
| Select Month & Strike best suited
for particular opinion:
The investor needs to build an understanding of the trade-offs that are part of the selection process. For example, a(n) August 60 Call costs less than a(n) January 60 Call. A 60 strike Call in October costs more than the 60 Call. Does the investor want to spend the additional money for the additional time or the lower strike price? Trade-offs: The selection process is full of choices. With four different expiration months and three, four, five or more different strike prices for each month, the investor is confronted with a long list of possible Call options to buy. Understanding the trade-offs involved in selecting and buying Call options is important. It is important to note that while Call buying is a strategy in and of itself, it is also a building block used in constructing more complex strategies. |
| Timing & Distance:
As a starting point, the investor should focus on the opinion that prompted the idea of buying XYZ Calls in the first place. In so doing, ask “What is the timing and magnitude of the anticipated rise in XYZ?” In this regard, Call buying is similar to planning a trip – “How far am I going and how long is it going to take to get there?” Trade-off #1: Oh, if only I had more … Time is like fuel! In order to make your final destination, you will need to have purchased an ample supply of fuel. Realizing that there are no refueling stations along the way, at which one could “pick up more time,” the investor must make sure to select a Call option with enough time until expiration. When buying Calls, running out of time can be costly! The problem every investor faces is deciding what qualifies as enough fuel! |
| Experience:
How to acquire good judgment in selecting the options to buy and sell? The answer is quite simple – years of experience full of numerous cases of noit-so-good judgment! Experience is a wonderful teacher. It will show not only how accurate your opinions tend to be (did the stock in fact rally?), but also your proficiency at calculating your fuel needs (did the rally take longer than you thought?). Experience plus Reserves: Successful Call buying is not easy! First, your opinion must be correct. Second, the strategy often fails even when the stock rises. This is true because the investor often runs out of time before the stock rises to a level that produces a profit. What can be learned from all of this?
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| Extra Fuel:
It is human nature for Call buyers to think that XYZ is going to begin to rally immediately and it’s going “straight up from here!” Sometimes this is the case. But, more often than not, extra time will become quite useful of the investor’s forecasted rally in XYZ occurs later rather than sooner. And who knows, maybe you will be forced to endure a few unanticipated detours (price declines) along the way. |
| Analysis of various expiration months:
Pros & Cons: Near-term options (+) Less $’s at risk. Most profitable if big advance occurs before expiration. (-) Larger % losses on near-term options if XYZ remains unchanged due to rapid time decay. Pros & Cons: Long term options (+) More time for rally to occur and to recover from any unexpected declines in XYZ that might occur along the way. (-) More $’s at risk if XYZ has a significant decline. Trade-off #2: Which strike price? Another part of the selection process is determining which strike price to buy. As mentioned earlier, there are often three, four, five or more strike prices per month available to the Call buyer. Determining which strike price to buy depends, to a certain extent, on the motivation of the Call buyer. A Call-buying stock investor views in-the-money (ITM) and out-of-the-money (OTM) Call options differently than a speculative Call buyer. ITM vs OTM Calls: In order to reach its break-even point, an OTM Call option requires a larger advance in XYZ than either an ATM or ITM Call option. Thus, owning OTM Calls is a much more bullish position. While OTM Calls may offer larger potential returns (%), they involve more risk. Even with a moderate advance in XYZ, an OTM Call may still expire worthless! By comparison, any rise in XYZ will increase the intrinsic values of both ITM and ATM Calls. Within the same expiration month, the lower the Call’s strike price, the higher its price. Given this fact, many Call buyers tend to select the OTM strike price Calls merely because they are cheaper in price. An important note of caution: The price of an option should not be the sole reason for its selection. If the investor can only afford to buy low-prices OTM Calls, he or she probably should not be buying Call options. |
The Call-buying Stock Investor: The investor who uses Call options as “capital” insurance sees OTM, ATM and ITM options as different types of insurance policies. An OTM Call is viewed as a cheap policy with a large deductible. An ITM Call costs more, but has a smaller deductible. An ATM Call option is in between the two. The deductible is simply the amount that XYZ must advance in order for the option to reach its expiration day break-even point. OTM Calls require a larger advance than ATM or ITM Calls. For example, an October 60 Call is purchased for 4 7/8 with XYZ at $60. Because it is an ATM Call, its price is equal to its deductible: break-even point (64 7/8) – stock price ($60). This deductible is simply the amount of the increase in the price of XYZ that the investor is willing to forego in order to have limited downside risk. No matter how high XYZ goes, the Call’s profit will always be 4 7/8 less than long stock. The Call-buying Speculator: In contrast, the speculator sees OTM Calls as an opportunity to gain more leverage by buying more of the less expensive OTM options than the more expensive ATM or ITM Call options. This is the key to understanding the thinking of the speculative Call buyer. The desire for big profits leads to an emphasis on the quantity purchased. Caution: Those who “swing for the fences” often strike out! |
| Analysis of various strike prices:
For options with different strike prices, it is easier to see the trade-offs that are part of the selection process. OTM Calls cost less, but are more likely to expire worthless. ITM Calls cost more, but start the investor out with at least some amount of intrinsic value. Risk/Reward Characteristics Break-even Point: At expiration, the break-even point (B.E.) is equal to the strike price of the Call option plus the Call option’s premium. Before expiration, the break-even point is lower. Profit: Profits are unlimited as long as the underlying stock continues in advance. Loss: Losses are limited to the premium paid for the option. At expiration, for every point XYZ is above the strike price, the Call option increases an additional point in value. Time Decay: A call option’s premium consists of both intrinsic value (if any) plus time value. As time passes, the time value portion of the Call erodes (i.e., decays). At expiration, the Call’s value will equal its intrinsic value. Note: The rate of decay accelerates as the option’s expiration date nears. Changes in implied Volatility: Changes in the option’s implied volatility has an effect on the “time value” portion of an option’s premium. Thus, a change in the option’s implied volatility has the same effect as changing (+/-) the number of days remaining until the option’s expiration. |
| Equivalent
synthetic position: (synthetic
= a strategy involving 2 or more instruments thas has
the same risk-reward profile as a strategy involving 1 instrument)
This strategy: Long 1 Oct 60 Call is equivalent to Long 100 Shares of stock + Long 1 Oct 60 Put. |