How Call Buying Works

When you buy a call, you are not required to buy the 100 shares of stock. You have the right, but not the obligation. In fact, the vast majority of call buyers do not actually buy 100 shares of stock. Most buyers are speculating on the price movement of the stock, hoping to sell their options at a profit rather than buy 100 shares of stock. As a buyer, you have until the expiration date to decide what action to take, if any.

You have several choices, and the best one to make depends entirely on what happens to the market price of the underlying stock, and on how much time remains in the option period.

Using calls to illustrate, there are three scenarios relating to the price of the underlying stock, and several choices for action within each.

  1. The market value of the underlying stock rises. In the event of an increase in the price of the underlying stock, you may take one of two actions. First, you may exercise the call and buy the 100 shares of stock below current market value. Second, if you do not want to own 100 shares of that stock, you may sell the option for a profit.
  2. Every option has a fixed value at which exercise takes place. Whenever an option is exercised, the purchase price of 100 shares of stock takes place at that fixed price, which is called the striking price of the option. Striking price is expressed as a numerical equivalent of the dollar price per share, without dollar signs. The striking price is normally divisible by 5, as options are established with striking prices at five‐dollar price intervals for stocks selling between $30 and $200 per share. Stocks selling under $30 have options trading at 2.5‐point intervals; and stocks trading above $200 per share have options trading at $10 intervals. When a stock splits, new striking price levels may also be introduced. For example, if a stock is split 2‐for‐1 and it has a current option at 35, the post‐split levels would be adjusted to 17½. (In cases of splits, the number of shares and options are adjusted so that the ratio of one option per 100 shares of stock remains constant. In a 2‐for‐1 split, 100 shares become 200 shares at half the value; and each outstanding option becomes two options worth half the pre‐split value.)
  3. The market value of the underlying stock does not change. It often happens that within the life span of an option, the stock's market value does not change, or changes are too insignificant to create the profit scenario you hope for when you buy calls. You have two alternatives in this situation. First, you may sell the call at a loss before its expiration date (after which the call becomes worthless). Second, you may hold on to the option, hoping that the stock's market value will rise before expiration, which would create a rise in the call's value as well, at the last minute. The first choice, selling at a loss, is advisable when it appears there is no hope of a last‐minute surge in the stock's market value. Taking some money out and reducing your loss may be wiser than waiting for the option to lose even more value. Remember, after expiration date, the option is worthless. An option is a wasting asset, because it is designed to lose all of its value after expiration. By its limited life attribute, it is expected to decline in value as time passes. If the market value of the stock remains at or below the striking price all the way to expiration, then the premium value—the current market value of the option—will be much less near expiration than at the time you purchased it, even if the stock's market value remains the same. The difference reflects the value of time itself. The longer the time until expiration, the more opportunity there is for the stock (and the option) to change in value.
  4. The market value of the underlying stock falls. As the underlying stock's market value falls, the value of all related calls will fall as well. The value of the option is always related to the value of the underlying stock. If the stock's market price falls significantly, your call will show very little in the way of market value. You may sell and accept the loss or, if the option is worth nearly nothing, you may simply allow it to expire and take a full loss on the transaction.

This example demonstrates that buying calls is risky. The last‐minute rescue of an option by a sudden increase in the value of the underlying stock can and does happen, but usually it does not. The limited life of the option works against the call buyer, so that the entire amount invested could be lost. The most significant advantage in speculating in calls is that instead of losing a larger sum in buying 100 shares of stock, the loss is limited to the relatively small premium value. At the same time, you could profit significantly as a call buyer because less money is at risk. The stockholder, in comparison, has the advantage of being able to hold stock indefinitely, without having to worry about expiration date. For stockholders, patience is always possible, and it might take many months or even years for growth in value to occur. The stockholder is under no pressure to act because stock does not expire as options do.

Example

Dashed Hopes: You bought a call four months ago and paid 3 (a premium of $300). You were hoping that the stock's market value would rise, also causing a rise in the value of the call. Instead, the stock's market value fell, and the option followed suit. It is now worth only 1 ($100). You have a choice: You may sell the call for 1 and accept a loss of $200; or you may hold on to the call until near expiration. The stock could rise in value at the last minute, which has been known to happen. However, by continuing to hold the call, you risk further deterioration in the call premium value. If you wait until expiration occurs, the call will be worthless.


Example

Limiting Risk: You bought a call last month for 1 (premium of $100). The current price of the stock is $80 per share. For your $100 investment, you have a degree of control over 100 shares, without having to invest $8,000. Your risk is limited to the $100 investment; if the stock's market value falls, you cannot lose more than the $100, no matter what. In comparison, if you paid $8,000 to acquire 100 shares of stock, you could afford to wait indefinitely for a profit to appear, but you would have to tie up $8,000. You could also lose much more; if the stock's market value falls to $50 per share, your investment will have lost $3,000 in market value.


Smart Investor Tip

For anyone speculating over the short term, option buying is an excellent method of controlling large blocks of stock with minor commitments of capital.

In some respects, the preceding example defines the difference between investing and speculating. The very idea of investing usually indicates a long‐term mentality and perspective. Because stock does not expire, investors enjoy the luxury of being able to wait out short‐term market conditions, hoping that over several years that company's fortunes will lead to profits—not to mention continuing dividends and ever‐higher market value for the stock. There is no denying that stockholders enjoy clear advantages over option buyers. They can wait indefinitely for the market to go their way. They earn dividend income. And stock can be used as collateral for buying or financing other assets. Speculators, in comparison, risk losing all of their investment, while also being exposed to the opportunity for spectacular gains. Rather than considering one method as being better than the other, think of options as yet another way to use investment capital. Option buyers know that their risk/reward scenario is characterized by the ever‐looming expiration date. To understand how the speculative nature of call buying affects you, consider the following two examples.

Smart Investor Tip

The limited life of options defines the risk/reward scenario, and option players recognize this as part of their strategy. The risk is accepted because the opportunity is there, too.


Example

Rising Hopes … and Prices: You buy an 80 call for 2 ($200), which provides you with the right to buy 100 shares of stock for $80 per share. If the stock's value rises above $80, your call will rise in value dollar for dollar along with the stock. So if the stock goes up $4 per share to $84, the option will also rise four points, or $400 in value. You would earn a profit of $200 if you were to sell the call at that point (four points of value less the purchase price of 2). That would be the same amount of profit you would realize by purchasing 100 shares of stock at $8,000 and selling those shares for $8,200. (Again, this example does not take into account any brokerage and trading costs. Chances are that fees for the stock trade would be higher than for an option trade because more money is being exchanged.)


Example

Falling Expectations: You buy an 80 call for 2 ($200), which gives you the right to buy 100 shares of stock at $80 per share. By the call's expiration date, the stock has fallen to $68 per share. You lose the entire $200 investment as the call becomes worthless. However, if you had purchased 100 shares of stock and paid $8,000, your loss at this point would be $1,200 ($80 per share at purchase, less current market value of $68 per share). Your choice, then, would be to sell the stock and take the loss or continue to keep your capital tied up, hoping its value will eventually rebound. Compared to buying stock directly, the option risks are limited. Stockholders can wait out a temporary drop in price, even indefinitely. However, the stockholder has no way of knowing when the stock's price will rebound, or even if it ever will do so. As an option buyer, you are at risk for only a few months at the most. One of the risks in buying stock is the lost opportunity risk—capital is committed in a loss situation while other opportunities come and go.

In situations where an investment in stock loses value, stockholders can wait for a rebound. During that time, they are entitled to continue receiving dividends, so their investment is not entirely in limbo. If you are seeking long‐term gains, then a temporary drop in market value is not catastrophic as long as you continue to believe that the company remains a viable long‐term "hold" candidate; market fluctuations might even be expected. Some investors would see such a drop as a buying opportunity and pick up even more shares. The effect of this move is to lower the overall basis in the stock, so that a rebound creates even greater returns later on.

The advantage in buying calls is that you are not required to tie up a large sum of capital nor to keep it at risk for a long time. Yet you are able to control 100 shares of stock for each option purchased as though you had bought those shares outright. Losses are limited to the amount of premium you pay.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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