Call Buying Strategies
Buying calls and hoping they increase in value is a basic, speculative strategy. It is the best-known option strategy, as well. More investors select calls than puts because they tend to think that prices are always going to rise; it is also an obvious strategy. But looking beyond this is where calls become the most interesting. Calls can also be put to work in ways beyond mere speculation.
Strategy 1: Calls for LeverageLeverage is using a small amount of capital to control a larger investment. While the term usually is applied to borrowing money to invest, it also perfectly describes call buying.
ExampleSpotting the Advantage: You are familiar with a pharmaceutical company's management, profit history, and product line. The company has recently announced that it has received approval for the release of a new drug. The release date is three months away. However, the market has not yet responded to the news. You expect that the stock's market price will rise substantially once the market realizes the significance of the new drug. But you are not sure; the lack of response by the market has raised some doubt in your mind. By buying a call with six months until expiration, you expose yourself to a limited risk; but the opportunity for gain is also worth that risk, in your opinion. In this case, you have not risked the price of 100 shares, only the relatively small cost of the option.
[caption id="attachment_12459" align="aligncenter" width="410"] Rate of return: buying stocks versus calls.[/caption]
ExampleExpanded Potential: Given the same circumstances as in the previous example, you also realize that price growth might not occur for one to two years. It may require market response and acceptance, so a short-term option will not provide the leverage you seek. A LEAPS call does provide you the long-term leverage in this situation. Buying a LEAPS call will require more investment, because you have to buy the additional time; but if you believe the stock has growth potential within the window of time, it would make sense to invest.
If you buy 100 shares, you are required to pay for the purchase within three business days. If you buy the call, you make payment the following day. The payment deadline for any transaction is called the settlement date.
As a call buyer, your plan may be to sell the call prior to expiration. Most call buyers are speculating on price movement in the underlying stock and do not intend to actually exercise the call; rather, their plan is to sell the call at a profit. In the example, a $500 investment gives you control over 100 shares of stock. That's leverage. You do not need to invest and place at risk $6,200 to gain that control. The stock buyer, in comparison, is entitled to receive dividends and does not have to work against the time deadline. Without considering trading costs associated with buying and selling calls, what might happen in the immediate future?
If a five-point gain occurred by the point of expiration, it would translate to only a two-point net gain for the option buyer:
|Less evaporated time value||-300|
|Original intrinsic value||$200|
|Plus increased intrinsic value||+500|
|Value at expiration||$700|
A point-for-point change in option premium value would be substantial. An in-the-money increase of 1 point yields 1.6 percent to the stockholder, but a full 20 percent to the option buyer. If there were to be no price change between purchase and expiration, three-fifths of the option premium would evaporate due to the disappearance of time value. The call buyer risks a loss in this situation even without a change in the stock's market value.
As a call buyer, you are under pressure of time for two reasons. First, the option will expire at a specified date in the future. Second, as expiration approaches, the rate of decline in time value increases, making it even more difficult for options traders to get to breakeven or profit status. At that point, increase in market value of the underlying stock must be adequate to offset time value and to yield a profit above striking price in excess of the premium price you paid.
It is possible to buy calls with little or no time value. To do so, you will have to select calls that are relatively close to expiration, so that only a short time remains for the stock's value to increase, and fairly close to striking price to reduce the premium cost. The short time period increases risk in one respect; the lack of time value reduces risk in another respect.
ExampleJust a Little Time: In the second week of May, the May 50 call is selling for 2 and the underlying stock is worth 51.50 (1½ points in the money). You buy one call. By the third Friday (the following week), you are hoping for an increase in the market value of the underlying stock. If the stock were to rise one point, the option would be minimally profitable. With only ½ point of time value, only a small amount of price movement is required to offset time value and produce in-the-money profits (before considering trading fees). Because time is short, your chances for realizing a profit are limited. But profits, if they do materialize, will be very close to a dollar-for-dollar movement with the stock, given the small amount of time value remaining. If the stock were to increase 3 points, you could double your money in a day or two. And of course, were the stock to drop 2 points or more, the option would become worthless. Considering trading costs, examples of small-point scenarios like this are most realistic for multiple-contract strategies. For example, if you were to buy 10 calls at $51.50, you would invest $510.50 plus trading costs; but on a per-contract basis, trading costs would be far lower than for a single-contract purchase.
Smart Investor TipShort-term call buyers hope for price movement, and they may need only a few points. The risk, of course, is that price movement could go in the wrong direction.
[caption id="attachment_12460" align="aligncenter" width="360"] Diminishing time value of the call
relative to the underlying stock.[/caption]
ExampleThe Luxury of Time: You buy a call at 5 when the stock's market value is at or near the striking price of 30. Your advantage is that you have six months until expiration. For four months, the underlying stock's market value remains fairly close to the striking price, and the option's premium valueâall or most time valueâdeclines over the same period. Then the stock's market value increases to $33 per share. However, because the time value has disappeared, the call is worth only 3, the intrinsic value. You have lost $200.
Strategy 2: Limiting RisksIn one respect, the relatively small investment of capital required to buy a call reduces your risk. A stockholder stands to lose a lot more if and when the market value of stock declines.
ExampleThe Lesser of Two Losses: You bought a call two months ago for a premium of 5. It expires later this month and is worth nearly nothing, since the stock's market value has fallen 12 points, well below striking price. You will lose your $500 investment or most of it, whereas a stockholder would have lost $1,200 in the same situation. You controlled the same number of shares for less exposure to risk, and for a smaller capital investment. Your loss is always limited to the amount of call premium paid. This comparison is not entirely valid, however. The stockholder receives dividends, if applicable, and has the luxury of being able to hold stock indefinitely. The stock's market value could eventually rebound. Options traders cannot afford to wait, because they face expiration in the near future.
Strategy 3: Planning Future PurchasesWhen you own a call, you fix the price of a future purchase of stock in the event you exercise that call prior to expiration. This use of calls goes far beyond pure speculation.
In this case, you would have two choices. First, you could sell the call at 18 and realize a profit of $1,500. Second, you could exercise the call and buy 100 shares of stock at $40 per share. If you seek long-term growth and believe the stock is a good value, you can use options to freeze the current price, with the idea of buying 100 shares later.
ExampleAll a Matter of Timing: The market had a large point drop recently, and one company you have been following experienced a drop in market value. It had been trading in the $50 to $60 range, and you would like to buy 100 shares at the current depressed price of $39 per share. You are convinced that market value will eventually rebound. However, you do not have $3,900 available to invest at the moment. You will be able to raise this money within one year, but you believe that by then, the stock's market value will have returned to its higher range level. Not knowing exactly what will happen, one alternative in this situation is to buy a LEAPS call. To fix the price, you can buy calls while the market is low with the intention of exercising each call once you have the capital available. The 40 LEAPS call expiring in 12 months currently is selling for 3, and you purchase one contract at that price. Six months later, the stock's market price has risen to $58 per share. The call is worth 18 just before expiration. The same strategyâlooking ahead one yearâwould not have been possible with shorter-term listed calls.
Some option speculators recognize that large drops in overall market value are often temporary, as a single-stock reaction to marketwide short-term trends. So a large price drop could represent a buying opportunity, especially in those stocks that fall more than the average marketwide drop. In this situation, investors are likely to be concerned with the risk of further price drops, so they hold off and miss the opportunity. As an options trader, you can afford to speculate on the probability of a price rebound and buy calls. When the market does bounce back, you can sell those calls at a profit.
Strategy 4: Insuring ProfitsAnother reason for buying calls is to protect a short position in the underlying stock. Calls can be used as a form of insurance. If you have sold short 100 shares of stock, you were hoping that the market value would fall so that you could close out the position by buying 100 shares at a lower market price. The risk, of course, is that the stock will rise in market value, creating a loss for you as a short seller.
ExampleChecking Your Shorts: An investor sells short 100 shares of stock when market value is $58 per share. One month later, the stock's market value has fallen to $52 per share. The investor enters a closing purchase transactionâbuys 100 sharesâand realizes a profit of $600 before trading costs.
ExampleReducing Your Risks: You sell short 100 shares when market value is $58 per share. At the same time, you buy one call with a striking price of 65, paying a premium of one-half, or $50. The risk is no longer unlimited. If market value rises above $65 per share, the call protects you; each dollar lost in the stock will be offset by a dollar gained in the call. Risk, then, is limited to seven points (the difference between the short sale price of $58 and the call's striking price of 65).
ExampleThe Need for More: A short seller pays a premium of 2 and buys a call that expires in five months. If the value of the stock decreases two points, the short seller might take the profit and close the position; however, with the added cost of the call, a two-point change represents a breakeven point (before calculating the trading costs). The short seller needs more decrease in market value to create a profit.
ExampleThe Effect of Rumors: An investor sold short 100 shares of stock at $58 per share. At the same time, he bought a call with a striking price of 65 and paid a premium of 2. A few weeks later, the underlying stock's market price rose on rumors of a pending merger, to a price of $75 per share. The short seller is down $1,700 in the stock (shares were sold at $58 and currently are valued at $75). However, the call is worth $1,000 in intrinsic value plus whatever time value remains. To close the position, the investor can exercise the call and reduce the loss to $700âthe sales price of the stock ($58), versus the striking price of the exercised call ($65 per share). In this case, an additional call with later expiration and higher striking price could be purchased to continue providing additional insurance. This overall strategy makes sense only if the investor continues to believe that the stock's value will eventually fall and recognizes that the use of calls is a valuable strategy while waiting out the short sale move. If the investor now believes that the stock is not going to fall, then continuing with the short sale in stock would not make sense; the smart move would be to close out the position and take the loss, before a larger loss occurs. Otherwise, if the stock's value continues to rise after the call has been closed, the investor risks further losses.
Strategy 5: Premium BuyingA final strategy involves buying calls to average out the cost of stock held in the portfolio. This is an alternative to dollar cost averaging (check Selling Puts: The Overlooked Strategy). Stockholders who desire to hold shares of a company's stock for the long term may want to buy stock while prices are stable or falling, on the idea that lower prices represent an averaging-down of the overall net price per share. However, the dollar cost averaging strategy, as effective as it is in a declining market situation, is not as desirable when stock prices rise. In that case, hindsight shows that you would have been better off to buy more shares at the original price.
This is a dilemma. If you plan to keep a stock as an investment over the long term, but you do not want to put all of your capital into the stock right now (fearing possible decline in value), one alternative is call premium buying. When you purchase a call using this strategy, you seek longer-term out-of-the-money calls for relatively low premium levels. Then, if the stock's value does rise, you can purchase additional shares below market value.
ExampleClimbing the Wall of Worry: You own 400 shares of a particular company and you want to buy another 200 to 400 shares in coming months. You originally planned to buy more shares any time the stock's price dropped, creating a lower average cost with each subsequent purchase. However, at the same time you are concerned about losing the opportunity to buy at today's price in the event the stock's price rises. You purchase two calls, one two points out of the money expiring in three months, the other seven points out expiring in six months.
Buying more shares of a company whose prospects are increasingly poor is never sensible. However, in utilizing an options strategy such as premium buying in conjunction with downward dollar cost averaging, we assume that the investor has performed the required level of fundamental analysis to be confident in the company's long-term value. This has to be offset against the cost of premium buying; you need to ensure that the money paid for call premium is not so excessive that the dollar cost averaging advantages are less than the advantages of simply buying stock at a higher price.
Strategy 6: Pure SpeculationThe last popular reason for buying calls is simply to speculate on price movement of the underlying stock. A speculator hopes the stock will move upward after the call has been bought because that is the only way profits will follow. Most speculators lose money on call purchases because time works against them, so it makes sense to speculate only if you have a good reason to believe the price of the stock is going to rise.
All time value premium is going to evaporate by expiration date, so the option premium has to rise enough to offset lost time value and to create enough intrinsic value to exceed the call's original cost. So if you pay a total of 4 ($400) and three of those points are time value, you need the stock to rise three points above the call's strike price just to break even.
With the problem of time value in mind, you have to pick calls carefully, based on the proximity between striking price and the current price of the stock. The closer the striking price to current price, the higher the extrinsic value is likely to be; and the farther away from expiration, the higher the time value. So the ideal situation involves several attributes:
- The call's striking price should be close to the current value of the stock.
- Time to expiration has to be adequate for the stock to have time to make a strong upward move. This is a difficult judgment call.
- As little extrinsic value as possible should reside in the call's premium. This enables the call's premium to be highly reactive to movement in the stock's price. In some situations, time value is nearly zero because "normal" time value is offset by reduced extrinsic value. This implies that there is little belief that the stock's price will rise in the money by expiration. In some situations, you can find calls with quite a long time until expiration that are nearly all time value, which results from this offset. Normal time value minus negative extrinsic value may create intrinsic value bargains.