Strategy for an Investment Club: Buying Calls Part II
June 11, 2010

Strategy for an Investment Club: Buying Calls Part II

See Part I in the previous post

The LIKE Sep 50 call (from the example) may cost $800.  When the stock is $57, it is 7 points above the strike price. That means the owner of such an option can (in theory only - no one would ever do this prior to expiration) exercise the call and pay $50 for stock.  Then the stock could immediately be sold at $57.  Net cash $700.  I hope this illustrates that this option is worth at least $700.  Other factors go into pricing an option, but that discussion comes later.

If you understand that this call is worth more than $700 in this scenario, that's good enough for today.  In the real world, this option may cost $800.

What do you get when you buy this call?

1) You own an option that move higher with the stock, but not quite point for point.  If the stock rises $2, your call will move (an estimated) $1.80.  You earn good money when the stock moves higher - but not quite as much as someone who owns 100 shares.  However, you cannot afford 100 shares, and invested only $800.  The other guy (the one with the stock) has to pay $5,700 to buy those shares. This $180 profit represents far more than you would earn if you held 15 shares (cost $825).  This is leverage at work: $180 for call owners vs. $30 profit for owners of 15 shares.

Keep in mind that it works the same when the stock declines by a few points.  You lose more than the owner of 15 shares..

2) Your option had an immediate value of $700, but you paid some 'time premium' to own it.  More on that 'time premium' at another time.  The point for today is this:  By the time expiration arrives, that extra $100 will disappear.  It's the price you pay to control those 100 shares with much less than $5,500.   If the stock is still $57, the call will be worth $700 and you will lose that $100.  If the stock is $60, the call is worth $10.  You paid $8, and the profit is $200.

3) You must sell this call before expiration.  You do not have enough cash ($5,000) to exercise it (to exercise, you buy 100 shares at the strike price, or $50 per share).  You don't want to own 100 shares anyway because that would be too much money invested in a single position.

In return for paying that time premium, you control 100 shares instead of only 15 shares.  That's good news on a rally, but bad news if the stock declines.  Thus, this is not for everyone.  You may  not want to lose as much as $100 per point if the stock declines..

Owning calls is a limited risk (maximum loss is the cash paid for the call) strategy that is a good idea for the investor who buys one call option instead of buying 100 shares.  For an investment club investing only $800, it's a big decision whether to buy one call option, knowing you are likely to gain or lose much more than you would by owning a few shares.  But, if you do opt for the call, please be certain it is in the money (the stock is higher than the strike price) by more than a few points.  You do not want to spend too much cash on time premium.

When you understand more of the details about options, we can return to this topic and discuss how to pick an appropriate call option and the rationale behind not buying much time premium. 

There are many different options you can purchase, and making the selection can be a frightening prospect - especially when it's your first option trade.

Mark D Wolfinger
Partner and Director of Public Relations

Expiring Monthly: The Option Traders Journal