Buying Calls

 

Success in call buying primarily depends on your ability to select stocks that will go up in price and to time your selection fairly well. Most investment strategies are designed to remove some of the risk and exactness in stock picking, thus allowing you to have some room for error and still make a profit. But that doesn't exist with pure play call buying.  Your total investment could be lost in an option play, even if the stock goes up. It has to go up enough and quickly enough to be profitable. For this reason, one should only use risk money when buying calls. The potential rewards in buying calls are so attractive to many investors and speculators that it is the most used options strategy by the investing public. The attraction of call buying is the leverage it gives a speculator. One could potentially realize large percentage profits from only a modest rise in price by the underlying stock. And even though they may be large percentage gains, the risks cannot exceed the fixed amount paid for the option originally. Calls have to be paid in full and cannot be bought on margin. Nor do they have any margin value nor contribute any equity to your margin account. Illustration of how a call purchase might work: Assume that ABC stock is selling at 48 and the 6-month call, the July 50, is selling for 3. With an investment of $300, the call buyer may participate, for 6 months, in a move upward in the price of the stock. If ABC should rise in price by 10 points (just over 20%), the July 50 call will be worth at least $800 and the call buyer would have a 167% profit on a move in the stock of just over 20%. This is the leverage that attracts speculators to calls. At expiration, if ABC is below 50, the buyer's loss is total, but is limited to his initial investment of $300, even if the stock declines substantially. Although this risk is equal to 100% of his investment, the dollar amount is still small. You should never risk more than 15-20% of your risk capital in call buying because of the high percentage risks involved. Some investors invest in call options on a very limited basis to add some upside potential to their portfolio. While investing in conservative stocks, and covered calls, they invest a small portion in buying calls on more volatile stocks. The investor will have a limited dollar risk by owning the option instead of the stock. It is very important to understand that the buyer of calls will only make money if the price of the underlying stock goes up.

Risk/Reward The cold, hard fact for the call buyer to recognize is that you will only make money if the stock rises in price. All the analysis in the world trying to decide which option to buy will not produce profits if the stock declines. However, this fact shouldn't dissuade you from making reasonable analyses in your call buying selections. Further, many times a speculator will pick the right stock, but the wrong option. The stock will go up, but not enough to be in-the-money, or not soon enough (prior to the expiration of the option). Since the only ally the call buyer has is upward movement in the underlying stock, the selection of the underlying stock is the most important choice you have to make. Since timing is so important too, technical analysis and current news, are more reliable indicators than fundamentals. You must be bullish on the stock to consider purchasing calls. Only after the stock has been selected can you begin to consider other important factors, such as strike price and expiration months. The purchase of an out-of-the-money call has both greater potential gains and risk than does an in-the-money call. Many call buyers will only buy out-of-the-money calls simply because they are cheaper. But the dollar amount should never be the deciding factor for which option to buy. If your funds are so low that you can only afford to buy out of the money calls, then you should not be investing in calls. The risks are too great. If a stock advances substantially, the out of the money calls will provide the best returns, but if it only advances moderately, then the in the money will perform better. Example: Assume ABC stock is at 60, the December 55 calls are at 5 and the Dec 65 calls are 2. If the stock moves up to 63 relatively slowly, the Dec 65 (out of the money) calls may actually experience a loss, even if the call has not yet expired. But the Dec 55 (in the money) calls will definitely have a profit because the call will sell for at least 8 points since that's its intrinsic value. So percentage-wise, an in the money call will have a better return if the stock moves modestly, while an out of the money call will have a better return if the stock moves up a great deal. An in the money call clearly has less risk. Timing is also a critical element. If you're relatively certain the stock will move up in the near future, then a short-term option offers the best deal. You won't be paying as much in time-premium. But if you're uncertain about the timing, then a farther out option is the better strategy.   Strategies Long Call Component Buy call Potential profit When the stock price is above the break-even point Unlimited, equals to the prevailing stock price minus break-even point Maximum loss Total premium paid Time value impact Negative Break-even Strike price plus premium paid   Example: Component Buy ABC June $200 Call Net Premium Pay $20 Break-even $200+$20=$220 Profit when Stock price is above $220 Potential Profit Stock price - $220 Potential Loss $20 Time Value Impact Negative