Friday, 23rd July 2010

Buying Calls

Written by George Traganidas Topics: Articles, Options, Wealth Building
By Nick Crow
August 12, 2009

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.

Buying (“buy to open”) 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, especially the options with strike prices near the current share price. Just as when you buy a stock, your maximum potential loss is the amount you invest — in this case, the premium you pay for the calls.

Of course, this brings up a logical question: Why not just buy the underlying stock outright? The main reason is to take advantage of controlled leverage. This leverage can magnify your results dramatically and, if you buy calls Foolishly, put less of your capital at risk. We’ll show you how with an example.

A Call in Action

Ideal candidates for buying calls are usually companies with (1) stocks that are significantly mispriced and (2) a catalyst (strong earnings, big news such as a merger or new product launch, and so forth) that can help unlock greater value prior to expiration. For example, assume a business you know well has had its stock crushed and now trades at $15 a share. You believe that once the market recognizes the overreaction, the stock will quickly recover. Prior to learning about options, you might have been willing to invest $3,000 in this idea, buying 200 shares at $15 apiece. Instead, let’s suppose that the $15 calls (using a strike price that’s the same as the underlying stock’s price for increased value) that expire in 17 months (the furthest date available) are trading for $2.90. Here, by just buying two call contracts — each representing 100 shares — you can profit from the same number of shares for only $580 ($2.90 x 2 x 100), thus risking much less capital.

But how much can you gain — or lose — with this investment? To better understand how buying calls works, let’s think of this example in terms of maximum profit, maximum loss, and breaking even.
Your Maximum Profit When Buying Calls

In theory, there’s no limit to how high a stock price can go — and in turn, call options can have unlimited profit potential. But, while that would be a spectacular outcome, let’s stay grounded.

Suppose your thesis proves true, and the stock moves up modestly, to $21 a share in six months. In this more realistic scenario, your options would likely be worth around $7. Multiply that $4.10 increase by 200 (two contracts representing 100 shares each), and you’re sitting on an $820 gain. That’s right: You’ve made 141% for only six months work. If you had purchased the stock, you’d be up 40% — still respectable, but a much smaller gain. Isn’t controlled leverage fun?

The Other Side: Your Maximum Loss When Buying Calls

Of course, there’s a flip side: Leverage makes losses occur more quickly. Fortunately, when purchasing an option, your maximum loss is limited to the premium you’ve paid — that’s why we refer to it as controlled leverage. In our example, your maximum loss is only $580, whereas the stock investor has $3,000 on the line. Of course, while the stock would need to drop to $0 for the stock investor to lose the entire investment, the same isn’t true for us as the options investor — but that’s one of the reasons we put less capital on the table to begin with.

Suppose your thesis doesn’t play out, and on the options’ expiration date, the underlying stock sits below your $15 strike price. The calls will expire worthless, and you’ll lose your entire $580 investment. But these losses don’t happen all at once at expiration; they occur over the life of a call contract (called “time decay”), which is why you can lose your investment so swiftly. Six months into our 17-month contract period, let’s say the stock dropped all the way to $13 a share. The stock investor would show a $400 loss. The option would likely be worth about $1.25, so you would show a smaller $330 loss. So although you’d already have lost much of your initial investment, you put less money on the table to begin with. This is the principal reason why we like to risk less capital: turbo-charged upside with a similar downside.

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.

Breaking Even

Just like it sounds, 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. In our example, that’s $15 (strike price) plus $2.90 (premium), so your break-even price would be $17.90. A good frame of reference here is to only buy a call option if you think the stock will at least achieve this break even performance — though of course, hopefully, you’ll do much better.

Which Call Should I Buy?

Here are a few guidelines that will help you when you’re buying calls:

  • 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 (if the dollar amount you’d be investing is close to equal, you’re buying too many options).
  • 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. Use whichever strategy you’re more comfortable with in each case.
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