Defining Call Profit Zones

Whatever strategy you employ in your portfolio, always be aware of how much price movement is required to create a profit, the risks involved in the strategy, and the range of potential losses to which you are exposed. Throughout the rest of this book, we will use illustrations to define the breakeven price as well as profit zone and loss zone for each strategy. See Figure for a sample. Note that prices per share are listed at the left in a column, and the various zones are divided according to price levels.

(As with all examples, these zones are simplified for illustration purposes, do not allow for the cost of trading, and usually involve single-option trades. Be sure to add brokerage fees to the cost of all transactions in calculating your own breakeven, profit, and loss zones.)

In this example, a loss occurs if the option expires out of the money, as is always the case. Because you paid a premium of 3, when the underlying stock's market value is 3 points or less above striking price, the loss will be limited. (Striking price was 50, so if the stock reaches 52, there will be 2 points of intrinsic value at point of expiration, for example.) With limited intrinsic value between striking price and 53, there is not enough increase in market value to produce a profit. Once the stock reaches $53 per share, you are at breakeven, because you are three points in the money and you paid 3 for the option. When the stock rises above the $53 per share level, you enter the profit zone.

[caption id="attachment_12462" align="aligncenter" width="340"]A call's profit and loss zones. A call's profit and loss zones.[/caption]


Example

A Math Quiz: You buy a call and pay a premium of 3, with a striking price of 50. What must the stock's price become by point of expiration, in order for you to break even (not considering trading costs)? What price must the stock achieve in order for a profit to be gained, assuming that only intrinsic value will remain at the time? And at what price will you suffer a loss?


Example

Timing Your Move: You have been tracking a stock with the idea of buying calls. Right now, you could buy a call with a striking price of 40 for a premium of 2. The stock's market value is $38 per share, two points out of the money. In deciding whether to buy this call, you understand that between the time of purchase and expiration, the stock will need to rise by no less than four points: two points to get to the striking price plus two more points to cover your cost. If this does occur, the option will be worth exactly what you paid for it, representing a breakeven level (before trading costs). Because the entire premium consists of time value, the stock needs to surpass striking price and develop enough intrinsic value to cover your cost. If price movement were to take place quickly, you could earn a profit consisting of both time and intrinsic value. So the illustration of breakeven and profit zones invariably assumes that all time value will be gone by the time you are ready to close a position.
[caption id="attachment_12463" align="aligncenter" width="300"]Example of call purchase with profit and loss zones. Example of call purchase
with profit and loss zones.[/caption]

Defining breakeven price and profit and loss zones helps you to define the range of limited loss in cases such as option buying, so that overall risk can be quantified more easily. An example of a call purchase with defined profit zone and loss zones is shown in Figure above. In this example, the investor bought one May 40 call for 2. In order to profit from this strategy, the stock's value must increase to a level greater than the striking price of the call plus 2 points (based on the assumption that all time value will have disappeared). So $42 per share is the breakeven price. Even when buying a call scheduled to expire within a few months, you need to know in advance the risks and how much price movement is needed to yield a profit.

Example

Going with Higher Potential: Another stock you have been following has an option available for a premium of 1 and currently is at the money. Expiration is two months away and the stock is only one point below breakeven (because of your premium cost). Considering these circumstances, this option has greater potential to become profitable. You need relatively little price movement to create a good profit. If the stock moves adequately at any time in the next two months, you will earn a profit.

In the first example, a breakeven price was four points above current market value of the stock, and the option premium was $200. In the second example, only one point of price movement is required to reach breakeven. The lower premium also means you are exposed to less potential loss in the event the stock does not rise.

You could make as much profit from a $100 investment as from an equally viable $200 investment, as the previous examples demonstrate. The size of the initial premium cost cannot be used to judge potential profit, whereas it can be used to define potential losses. Premium level can be deceptive, and a more thoughtful risk/reward analysis often is required to accurately compare one option choice to another.

Smart Investor Tip

The option's premium level cannot be used reliably to judge the viability of a buy decision. It can be used to define potential losses, however.

The calculation of the profit you need and even of the profit zone itself is not always a simple matter. In the previous section, the example of General Motors calls was given to demonstrate that a call with 13 months until expiration consisted almost entirely of intrinsic value. This is a real opportunity for speculation because anything can happen. For example, if the market pessimism about a company were to change suddenly (e.g., if GM got its bailout or its union agreed to drastically change its contracts), then market perspective could change quite rapidly. In this event, two things change. The stock price would rise, of course, but the option premium would adjust as well. This means not only a higher overall premium, but potentially a dramatic increase in extrinsic value.

When prospects for profitable changes in the stock price improve, extrinsic value can change even more rapidly. So the call premium would be likely to rise on the volatility and uncertainly, but also on the increased potential for future price movement. Just as pessimism suppresses extrinsic value unreasonably, optimism is just as likely to exaggerate extrinsic value beyond rational levels.

Another factor to consider when evaluating potential profit is the tax effect of buying options. By definition, a buyer's listed option profits and losses are always short-term because listed stock options expire within one year or less; LEAPS profits may be either short-term or long-term depending on how long the positions are open (see Risk and Taxes: Rules of the Game). So you need to consider the tax consequences of profits as part of the breakeven analysis. The transaction cost also has to be calculated on both sides of the transaction, of course. You probably need to calculate the after-tax breakeven point, which is the profit required to break even when also allowing for the federal, state, and (if applicable) local taxes you will owe.

Option profits are taxed in the year a transaction is closed. So option sellers receive payment in one year, but the option may expire or be closed in the following year. In that situation, the option profit is taxed in the latter year, when the option has been closed, exercised, or expires. This raises individual tax planning questions. Risk and Taxes: Rules of the Game explains the tax considerations in detail.

Example

A Taxing Matter: You bought a call two months ago and you want to identify the after-tax breakeven point. Your effective tax rate (combining federal and state) is 50 percent, so your breakeven cannot simply be restricted to the calculation of pretax profit. Even though the true breakeven point is variable (because as you earn more, a higher amount of taxes will be due), you should build in a 50 percent cushion to the breakeven calculation. If you were to make $200 on an option transaction, $100 would have to go to pay a combined federal and state tax liability, so you would have to raise the breakeven by two more points to create an after-tax breakeven of $200 ($400 pretax profit minus $200 tax liability).

The important point to remember about taxes is how that figures into your overall goal setting. A "profit" is going to be much smaller if your tax rate is high, and combined federal and state rates can take a significant share of your pretax profit.

The after-tax breakeven point has to be calculated figuring both federal and state rates. The only way you can keep 100 percent of your profits is when you have a carryover loss, which can be deducted only at the rate of $3,000 per year on your federal return. However, if you have profits in the current year, you can offset those profits against your unused carryover losses and shelter current-year profits. These are among the many considerations to keep in mind when developing a strategy for buying options.

Before buying any option, evaluate the attributes of the underlying stock and the profit or loss potential of the option. The analysis of the underlying stock should include, at a minimum, a study of market price, dividend history and rate, price volatility, price/earning (PE) ratio, earnings history, and other fundamental and technical features that define a stock's safety and stability. There is no point to selecting an option that has price appeal, when the underlying stock has undesirable qualities, such as price unpredictability, inconsistent financial results, weak position within a sector or industry, or an inconsistent dividend history. At the very least, determine from recent history how responsive the stock's market price is to the general movement of the market. Options cannot be evaluated apart from their underlying stock, because that would ignore the important risk attributes of the stock and its potential volatility. The value and profit potential in your options strategy grows from first selecting stock candidates that are a good fit with your own risk profile. It is the wise selection of a range of "good" stocks (by the definition you use to make stock value judgments) that determines viable option selection.

You may also evaluate the entire stock market before deciding whether your timing is good for buying calls. For example, do you believe that the market has been on an upward climb that may require a short-term correction? If so, it is possible that buying options, even on the best stock choices, could be ill timed. No one truly knows how markets will move, or why they behave as they do, even though you may find yourself on a continual quest to find a method to gain such insights. The process of buying and selling is based, invariably, on timing and opinion. Check Choosing Stocks: Finding the Right Ingredients for a more in-depth and expanded study and discussion of stock selection.

Beyond the point of stock and option analysis, observe the time factor and how the passage of time affects option premium. Time value changes predictably, but in different degrees by stock and from one period to another. Changes in time value can be elusive and unpredictable in the degree and timing. The only certainty is that at expiration, no time value will remain in the option premium.
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.

Posted in ...