Understanding the Limited Life of the Call
You can become a call buyer simply for the potential profit you could earn within a limited period of timeâin other words, buying purely on the chance of earning a profit in the short term. That profit will be realized if and when the call's premium value increases, so that the call can be sold for more than it cost, or by exercising the call and buying 100 shares of stock below current market value.
The buyer's risks are not the same as those for sellers; in fact, they often are the exact opposite. Before becoming an options buyer, examine all of the risks, become familiar with potential losses as well as potential gains, and review risk from both sides: as potential buyer or seller. Time value evaporates with ever-increasing speed as expiration nears, which is a disadvantage to you as a buyer but an advantage to the seller. Time is a significant factor that affects your decision about when to close out your long position in the option. Because time value disappears by the point of expiration, time itself dictates which options you can afford to buy, and which ones are long shots. More time value usually means more time until expiration, and more price movement that you will need to make a profit. In fact, even when the stock price movement goes the way you want, you still might not make a profit; price movement has to exceed the number of points of time value and more to produce a profit.
This is where comparisons between listed options and LEAPS options become interesting. For example, you might look at side-by-side options with identical striking prices and come to different conclusions about their viability.
ExampleInto the Stretch: A stock is currently valued at $48 per share. The 50 call expires in eight months and is currently selling for 3. If you buy that call, it will be necessary for the stock to rise at least five points to $53 per share before expiration, just to cover your costs before trading fees (such a rise would produce intrinsic value of 3 points, producing breakeven before trading fees).
ExampleTaking the LEAPS: The picture is far different when a LEAPS call is reviewed. For the same stock, currently valued at $48, the 50 call that expires in 29 months is valued at 9. In this situation, the call costs three times moreâ$900 versus $300âbut you have 30 months for the stock to move, instead of eight months. You would need the stock to rise 11 points, to $59 per share, to break even in this case.
Smart Investor TipTime works against you as a buyer, so the more time value in the option you buy, the more difficult it will be to make a profit.
When you consider the interaction between intrinsic and time value of calls, you quickly realize that time itself plays a very crucial role in option value. The longer the time until expiration, the more complicated this relationship becomes. For this reason, the LEAPS option presents many interesting possibilities for speculators.
Intrinsic value rises and falls to match the underlying stock's price. But because a LEAPS call is long-term, the action of time value often obscures the relationship between intrinsic value and underlying stock price. It might appear as though the call's value is not tracking the stock point for point. With a lot of time value remaining in a call's premium (including both time and extrinsic segments), it is possible that the call's value will not respond to changes in the stock as clearly as it does when expiration is imminent.
ExampleMaking the Long Call: You purchased a LEAPS call last month with a striking price two points above market value of the underlying stock. Since then, the stock's price has risen and the LEAPS call is now in the money. But you have noticed that as the stock's market value rises and falls, the LEAPS call tends to duplicate the change only about 75 percent (so when the stock rises one point, the call rises 75 cents). This is caused by changes in perception of extrinsic value, offsetting the tendency of intrinsic value by itself.
As expiration approaches, extrinsic value becomes a smaller factor and will disappear from the picture altogether. But as long as many months remain until expiration, intrinsic value cannot operate independently. Some nonintrinsic changes will occur as well. This may be seen as point changes lower than changes in the underlying stock's value, or point changes higher than the point change in the underlying stock. That is the effect of extrinsic value interacting not only with time but also with intrinsic value.
Is call speculation appropriate for you? Questioning risk levels is necessary for every investor and should be an ongoing process of self-examination. Knowing exactly what you are getting into, determining the best strategy, and fully comprehending the risk add up to the measure of your suitability for a particular investment or strategy. Suitability identifies what is appropriate given your income, sophistication, experience, understanding of markets and risks, and capital resources. Avoid the problem of understanding the profit potential of a strategy but not the full extent of risk.
ExampleMy Friend Told Me: An investor has no experience in the market, having never owned stock; he also does not understand how the market works. He has $1,000 available to invest today, and decides that he wants to earn a profit as quickly as possible. A friend told him that big profits can be made buying calls. He wants to buy three calls at 3 each, requiring $900, plus trading fees. He expects to double his money within one month.
Suitability refers not only to your ability to afford losses, but also to your understanding of the many forms of risk in the options market. If the investor in the preceding example worked with an experienced broker at the onset, it would also make sense to listen to that broker's advice about a proposed option position.