The Practical Way

Friday, 23rd July 2010

Buying Calls

Written by George Traganidas Topics: Options, Wealth Building

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Buying call options is a lot like purchasing stock: You believe that a company you understand well will grow in value over a certain period of time, and you want to generate a profit from it. When you buy a call, you have the right to buy the underlying stock at a set price (the strike price) by a specified date (the expiration date). If the stock price goes up, the value of its calls will too.

In theory, there’s no limit to how high a stock price can go — and in turn, call options can have unlimited profit potential.

When purchasing an option, your maximum loss is limited to the premium you’ve paid. It usually makes sense to exit a losing position before the expiration date in order preserve some capital, but sometimes an option loses so much value that selling it makes little sense. To be safe, you need to be prepared to accept a full loss.

An options strategy’s break-even point is where the stock price needs to be at expiration for you to neither make nor lose any money. When you buy a call, the break-even point is the strike price plus the premium you paid. For example, if the strike price is $30 and the premium is $5.80, your break-even price would be $35.80 (strike price + premium).

Why buy calls?

• You believe a stock has a strong catalyst for appreciation over the coming months or few years.
• You want to benefit from a stock’s upside, but put less capital at risk than buying the stock outright.
• You want to leverage your bullish expectations on a stock you already own.

Which Call To Buy?

• The option should be on a business that (1) you know well, (2) you have good reason to believe is worth much more than its current stock price, and (3) has a catalyst that should help the stock reach your fair value estimate prior to the option’s expiration date.
• When choosing an expiration date, make sure to allow enough time for your catalyst to pan out. These things sometimes take longer than expected, so it can be wise to use options that expire as far out as possible.
• Don’t overleverage – you’ll be risking a very large loss. Only purchase enough contracts to cover the same number of shares you’d be purchasing as a long stock position. For example, if you’d be purchasing 300 shares, stick to just buying three contracts. This will cost significantly less money than a stock purchase.
• When it comes to strike prices, you have two choices: Buy a deep in-the-money call (meaning the strike price is well below the stock price — at the very least, 10%) that will cost more, but that lets you more easily convert the calls to stock if you need more for your catalyst to play out. Or you can buy an out-of-the money call that will cost less, but that increases your odds of losing your whole investment if the stock doesn’t increase above the strike price.

Buying calls is a straightforward option strategy that lets you leverage a bullish stock idea, in a shorter period of time, while putting less capital at risk than buying the stock outright. The strategy works best if you expect the stock to go up within a defined time frame. You have unlimited upside when you buy calls; however, as with any option purchase, if it works against you, must be prepared to lose what you paid for the options.

Follow the practical way,
George Traganidas