Judging the Call
Most call buyers lose money. Even with thorough understanding of the market and trading experience, this fact cannot be overlooked. This statement has to be qualified, however. Most call buyers who simply buy calls for speculation lose money. There are many additional reasons for buying calls, and there are specific strategies to avoid loss. These are explained in Combined Techniques: Creative Risk Management
The biggest problem for call buyers is lack of enough time.
ExampleWhen Four Equals Two: You recently bought a call for 4 when it was at $45, at the money (the current market value of the underlying stock was identical to the call's striking price). By expiration, the stock had risen to $47 per share, but the call was worth only 2. Why? The original $400 premium consisted entirely of time value and contained no intrinsic value. The time value was gone by expiration. The $200 value at closing represents the two points of intrinsic value. In this case, you can either sell the call and get half your money back, or wait it out hoping for a last-minute surge in the stock's price. Otherwise, you may simply allow the call to expire and lose the entire $400.
Smart Investor TipThe increase in premium value of an in-the-money option takes place in intrinsic value. Time value has to be absorbed, too, and as expiration approaches, time value evaporates with increasing speed.
ExampleAll for Nothing: You bought a call two months ago and paid 1. At the time, the stock was 7 points out of the money. Now expiration date has arrived. The stock's market value has increased an impressive six points. However, the option is virtually worthless because, with expiration pending, there is no intrinsic value. The call is still out of the money, even though the underlying stock's market value has increased six points.
This is always a problem for anyone taking up a long position with options. You buy hoping the call will grow in value, but time works against you. In fact, three-quarters of all options expire worthless, so making a profit consistently buying options is a difficult task. You need to overcome time as well as realizing growth in intrinsic value; and, of course, interim changes in extrinsic value further complicate this requirement. As a buyer, you race against time. It makes a lot of sense to set goals for yourself, but the time may also come when you realize you are going to make a profit because time is evaporation. With this in mind, your goal should include identifying when to take a loss.
Smart Investor TipKnowing when to take a profit is only a part of the option trader's goal. It is equally important to know when to take a loss.
ExampleKeeping Promises: You are the type of investor who believes in setting goals for yourself. So when you bought a call at 4, you promised yourself you would sell if the premium value fell to 2 or rose to 7. This standard reduces losses in the event that the option declines in value, while also providing a point at which the profit will be taken. You recognize that when it comes to options, time is the enemy and an opportunity might not return. Option buyers often do not get a second chance.
If you buy a call and the stock experiences an unexpected jump in market value, it is possible that the time value will increase as well, but this will be temporary; to realize the profit, it has to be taken when it exists. The wider the out-of-the-money range, the lower your chances for realizing a profit. The leverage value of options takes place when the option is in the money. Then the intrinsic value will change point-for-point with the stock. As shown in Figure below, whenever a stock is five points or more below the call's striking price, it is described as being deep out of the money. For puts, the number of points is the same, but the stock's market value would be five points or more above striking price. If the stock's market value is five points or more above striking price (for calls) or below striking price (for puts), it is said to be deep in the money.
[caption id="attachment_12457" align="aligncenter" width="350"] Deep in/deep out stock
prices for calls.[/caption]
These definitions are important to call buyers. A deep-out-of-the-money option, because it requires significant price movement just to get to a breakeven point, is a long shot; and a deep-in-the-money call is going to demand at least five points of premium just for intrinsic value, in addition to its time value. So the majority of call buyers will buy within the five-point range on either side of the striking price. This provides the maximum opportunity for profit with the least requirement for price increase to offset time value.