Call Option Buying

Call options are arguably the easiest trading strategy there is.

What are options:  Options are contracts to buy or sell stock at a given price by a certain date.

Options come in two varieties: Calls and Puts.

Both calls and puts grant the buyer the right, but not the obligation, to buy or sell stock.

Both calls and puts impose on the seller the obligation to sell stock.

As the chart above shows, one can either buy or sell both calls and puts.  Whether one buys or sells these options grants him or her either a right or an obligation.

Some concepts to understand about options: 

 

1. Options are listed in strike prices at specific intervals, depending on the underlying stock price.
2. Options are said to be wasting assets because they have expiration dates.
3. Stock prices are listed as for a single share of stock.
4. Each option controls 100 shares of stock.
5. The price of an option is comprised of intrinsic and time value.
6. Options expire typically on the third Saturday of every month.

How does this work in practice:  Firstly, I will not calculate commissions for the sake of this article.  Commissions vary widely from broker to broker, but some excellent brokers have very reasonable commission costs.

Above I stated that call options grants the buyer (owner) the right to buy stock at a certain price before a certain date.  Suppose you buy a Microsoft (symbol MSFT) $33 call option with an expiration date of December 2012.  What this means is that you want to own the right (but not the obligation) to purchase MSFT by the latest December 2012 at a limit price of $33.  For that right, you must pay a price, and as of closing prices September 25, 2012, the December 2012 $33 call was going for $0.34.  You have just purchased the right to buy MSFT for $33, and your breakeven cost would be $33.34, to account for the cost of the call option.  Why would you want to buy this call option?  Because you think that MSFT is going higher.  At today's close, MSFT traded at $30.78.  If it rises by December expiration to $35, and your breakeven is $33.34, you're ahead of the game by $1.66, or $166.00, because you can exercise your call option and buy it at $33.00, which is cheaper than going out on the open market to purchase the stock.  Moreover, if you buy 100 shares of MSFT at the current price ($30.78), you would have to spend $3078.00 ($30.78 x 100) - (remember, stock prices are listed in single-share prices) but buying an out-of-the-money (OTM) call option only costs you $34.00 ($0.34 x 100).  A dramatic difference.

Since I introduced the term "out-of-the-money" above, let's explain this term.  All options (puts and calls) have strike prices.  For calls, if the strike price is lower than current market price, the option is said to be in-the-money; if exactly at the current market price, the option is said to be at-the-money; and if above current market price, it is said to be out-of-the-money.  The reverse is true for puts, where if the strike price is under the current market price, it is said to be out-of-the-money; if exactly at current market price, the option is said to be at-the-money, and if above current market price, the option is said to be in-the-money.  Let's put this in a table, as above.  Let's stay with MSFT, closing today at $30.78.

CALLS

• ITM - $30.00
• ATM - $30.78
• OTM - $33.00

PUTS

• ITM - $33.00
• ATM - $30.78
• OTM - $30.00

Strike prices are usually listed in 2.5, 5 and $10, and above, so you will not see a strike price of $30.78.  The ATM figure above is for illustration only.

Intrinsic and Time Value.  Each option consists of Time Value.  But not so with Intrinsic Value.  In the case of MSFT, if the current market price is $30.78, a $33 call option is said to be "out of the money" because its entire cost consists of time value only.  Time value is the portion of the option that is the so-called wasting part.  You may ask, what is time value? Time value refers to the portion of the option that covers the time chance of the stock moving that high.  For example, in weather, you may hear forecasts of a "15 percent chance of a hurricane occurring in December."  That would be equivalent to a "time" chance.  The more time you give an option to "cook," so to speak, the more you should pay for it.

You no doubt have heard that approximately 80 percent of all options expire worthless.  This refers specifically to the time value of an option.  It is this portion that erodes with time.

To repeat, if MSFT rises to $35.00 by the December 2012 expiration, it would be more profitable to purchase MSFT at your agreed-upon price of $33.00 than to go to the open marketplace and purchase it at $35.00.  You paid $0.34 for the privilege of buying it at $33.00, so your total out-of-pocket in this case would be $33.34 - still lower than the market price of $35.00.  In fact, what you have done by purchasing that call option is that you have effectively "locked up" a purchase price of $33.00 per share, no matter how high MSFT rises by the expiration date.

Limited risk:  We have been talking about how to profit if the price of MSFT rises to $33.00 by expiration.  But what happens if it declines?  If MSFT declines from its current price, or simply does not rise enough to cover your breakeven of $33.34, you would lose the entire cost of your option of $0.34, or $34.00 ($0.34 x 100 shares).  But that is the most you can lose.  That's one of the benefits of options - that they limit your risk.  That is precisely what the "futures" markets do - they try to lock up prices in the future and not run the risk of having them increase inordinately.

The title of this article is, Why I don't buy call options.  With the above explanation, you might think that limiting my risk to "only" $34.00 seems like a wonderful idea.  It might be, but consider that if I buy a call option, I need the underlying stock to do two things: move up, and move up in a timely manner.  When you hear the axiom that 80 percent of all options expire worthless, that is what they are referring to: the chances of a stock moving to a target price in a given period of time frequently does not occur, and many (80 percent) call options expire.

A Great Way to Make Money

Insurance companies are the ideal businesses.  Well, almost.

Stock options have gotten a bad rap.  And yet, some strategies are so safe, the government permits them in IRA accounts. 

Some think that option techniques are complicated, full of jargon, full or arcane numbers and obscure formulas.  That may be true in academic circles, but for practical application, it needn't be.  There are some principles that must be understood, but they are not complicated.  For example, you know that to lose weight, you need to take in fewer calories than you expend.  That's it; it's really no more complicated than that.  However, the application of that formula has brought many to tears.  For another analogy, you already know that you should save a certain amount of your paycheck for a rainy day.  Again, simple formula, but perhaps difficult implementation.  But the difficulty arises not from the formula itself, but rather because of people's unwillingness to play the game, people's resistance to learning the rules of the game, and the almost universal desire to have things handed to them on a platter.

What if I told you that it's easy to make money? Your tendency would be to resist my assertion, perhaps pointing out to me that if it were so easy, everybody would be rich.  True, but the problem is that "everybody" does not apply the rules, and indeed, does not even bother to play the game.

Selling naked puts is my favorite strategy.  Some readers may have heard that naked puts are risky.  In fact, they are no more risky than covered calls, the same strategy permitted by the government in retirement accounts.  So what does selling naked puts entail?

Without getting too elaborate, options come in two varieties: calls and puts.  Calls represent the right to buy; puts represent the right to sell.  One can either buy or sell either calls or puts.  Both calls and puts cover lots of 100 shares of stock, where 1 option controls 100 shares.  Both calls and puts are represented by strike prices.  Strike prices are either at the current market price of the stock, in this case MSFT at $31 and are known as at the money (ATM), below the current market price of the stock are out of the money or in the money (OTM for puts, ITM for calls), or above the current market price of the stock, known as in the money for puts and out of the money for calls (ITM for puts, OTM for calls).  With MSFT currently at $31,

                        PUTS              CALLS

Strike 30                    OTM                  ITM

Strike 31                    ATM                  ATM

Strike 32                    ITM                    OTM

Moreover, options are "wasting assets" because the life of the option has a time limit.  Let's also stipulate that options are traded within a brokerage account, such as Fidelity or OptionsXpress, or any number of other brokers. 

Since this article is about selling naked puts, let's explain this a bit more deeply.

A put option represents the right to sell, specifically, to sell a stock.  Frequently, people will buy a put option to protect their portfolio.  How does that work?  Suppose you own 100 shares of Microsoft (symbol: MSFT) that you've been accumulating over the years, or received as a gift.  At its current price of $31, your 100 shares are worth $3,100.  If you are worried about the stock falling and losing some of your money, you would buy a put option at, say, a strike price of $30.  Recall that a put represents the right to sell (a stock).  If MSFT falls to $27, you own the right to sell the stock at $30, which was the strike price of the put you purchased. So, it would not bother you that MSFT had fallen to $27 if you own the right to sell it at $30.  So, the put gives its owner the right to sell the respective stock at the strike of the put option.  Recall, too, that the put option has a time limit - the longer the expiration date, the longer you can hold onto this protection of MSFT at $30. 

Now, if you bought the put option, someone had to sell it to you.  Why would someone wish to do that?  Because when you sell something, anything, you get the money (and likewise, when you buy something, you spend the money).  And what was the intention of that seller of the put? That seller essentially took on the risk that MSFT would stay at its current price, and not fall.  For that risk, the seller received a premium (from the buyer who wants to protect his MSFT shares).  In this case, the seller sold a naked put, meaning that his/her put does not have a corresponding position.  It's out there, alone, unsupported.  He is taking a risk, and for that, he is being paid. 

Imagine the same situation in real estate.  You, as a buyer, are interested in buying property in this depressed market, thinking that you'll snatch a real bargain.  You look at several properties, and find one that you really love.  But you want to keep your door open, to find other properties that are even better.  So you give the seller an option to buy the property at, say, $200K.  You are buying an option to buy that property (while the seller is selling you an option to buy the property) at a certain price by a certain date, say 6 months.  And for the privilege of "holding" the property at $200K for the next 6 months, you are willing to pay the seller a premium to cover his risk of higher prices.  Why is that a risk for the seller? Because the market may suddenly switch course and rocket higher, while he, the seller, has just committed to sell you his property at the lower price of $200K.  If, at the end of 6 months, you have not completed your contract by buying the house, the seller keeps the premium you paid. 

So it is with put options.  By selling a put, the seller collects a premium for essentially selling insurance on the stock, taking on the risk that the stock would fall.  For that, he receives a premium, just as insurance companies do.  But under the right conditions, expiration of the option term arrives and the stock has not fallen, the entire premium remains in the seller's pocket. 

Let's see how this works out in the "real" world.

MSFT's closing price as of 09/07/2012 was $30.95.  For the sake of this article, let's call it $31.  Suppose someone wants to sell a put on MSFT at a strike of $30 expiring in December 2012.  That put is currently priced at $1.12.  Please recall that options are represented in lots of 100, so the $1.12 would really be $112.  He receives the $112 in his account the very next day, and he is free to use that money as he sees fit.  What the seller is betting is that MSFT will not go below $30 by expiration December, and he will keep his entire premium of $112. 

But wait, there is more!

In order for a person to be able to sell this insurance, the brokerage house requests a certain collateral be put up against the risk of the stock falling.  The formula for such collateral is not complicated, and is as follows:

Price of stock x20 percent + premium received - any out-of-the-money amount

Wait, what's "out of the money"? As depicted above, a put strike below the current market price is known as out of the money (OTM).

So, accounting for an option controlling 100 shares, let's multiply our numbers by 100.  Plugging in the numbers into the formula, we get the following:

$3100 x 20 percent =$620 + $112 (premium received) - $100 (OTM amount) = $632 as collateral.

If December expiration arrives and MSFT is still above $30, then the put expires worthless, and you, the seller, get to keep the entire $112 you received as premium.  But, you say, this isn't such a big deal!  No, not yet, not until you realize that $112 represents 17.72 percent return on your money in three months ($112/$632=17.72 percent).

If 17.72 percent return in three months is not to your liking, imaging going out farther than December, to, say, January of 2014.  Now, the $30 put premium expiring in January of 2014 is $3.85, or $385 for each contract that controls 100 shares.  Your return in this case would be:

            $3100 x 20 percent=$620 + $385 - $100=$905.

And your return percentage:  42.54 percent for a year and a half.  Not bad in my book.

Time Value vs. Intrinsic Value

Recall that options come in two varieties: Calls and Puts.  Both calls and puts can be bought or sold.  That's a total of four possible moves, but within those four moves are innumerable possible permutations.  For the sake of this very simple explanation, let's focus on what is meant to Time Value and Intrinsic Value.

First, Intrinsic Value.  As the term suggests, intrinsic means inherent, built-in, real value.  Let's consider a call option on Apple Computer (AAPL).  The stock is currently trading at about $350.  If you buy a call option at a $320 strike price expiring in May 2011, that means you are buying the right to buy AAPL at $320 on or before May 20, 2011.  For that right, you would pay $33.60 on the ask (you buy at the ask and sell at the bid).  For 1 contract, the total cost would be $3360.  With the stock currently around $350, that means that a full $30 of the cost of the $320 call is intrinsic value, or in the money (ITM).  You are therefore buying some "real meat," if you will.  You are buying some portion of the stock itself.  The remaining cost of the option ($33.60-$30.00=$3.60) is Time Value. 

All options, both calls and puts, have what is known as intrinsic value and time value.  Time value is that portion of the option that erodes over time.  It is much cheaper, dollar-wise, to purchase only time value (out of the money OTM) call options, but the risk is greater.  More on that later.  In the case of AAPL, as above, by spending $3360, you are actually positioning yourself to profit very closely to the movement of the stock itself; if AAPL rises by $1, your call option is likely to appreciate by a similar amount (called the delta - more later).  The delta of ITM call options is significantly higher than deltas for time value call options.

Covered Calls With a Twist

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First, a definition: Covered Calls are Call options sold on stock that one owns.  One does that in order to generate income.

Say you own some shares of QQQ (an ETF of Nasdaq 100 shares).  The closing price on April 21, 2011 was $58.34.  You need a minimum of 100 shares of stock in order to be able to sell covered calls on those shares, therefore, your out-of-pocket outlay to buy those shares is $5834.00.  Assuming you own at least 100 shares, and you wish to generate some income, rather than simply waiting for continued increase in the stock itself, you search the option tables and various expiration dates, and determine that you would be happy to part with your shares at $59.  The May 2011 $59 strike call options are trading at $.55 bid x $.57 ask.  If you sell 1 contract per 100 shares of the May 2011 $59 strike calls, you will receive $55.00 into your account.  By doing so, you have committed yourself to part with the underlying stock at $59 by Friday, May 20, 2011.  Since the stock is currently at $58.34, selling it at $59 means an additional amount of $.66, or $66.00.  Add that to the $55 premium received for selling the calls, and your total gain is $121.00.  If you bought the QQQ at $58.34 and sold those calls, your return would be 2.07% for less than 4 weeks.  That translates to a return of 26.96% per year. 

What's the twist? You can buy call options on the QQQ and sell call options against the ones you own.  Remember from prior entries that you can buy Call options with any expiration date, and at any strike price.  Let's assume you are long-term bullish on the direction of the Nasdaq, and are willing to buy the basket ETF, the QQQ.  You do not want to monitor your position every day, so you buy the 2013 expiration $60 strike price, currently listed as $5.32 bid x $5.49 ask.  You buy at the ask.  Ten contracts which control 1000 shares cost $5490.00, essentially the same as buying 100 shares of the ETF itself.  In order to create a spread, and thereby mitigating your cost, you now sell calls against this position.  If you decide to sell the May 2011 $60 strike calls, you will receive $220 ($.22 bid x $.23 ask).  Assuming the QQQ closes at less than $60 by May 20, 2011, your total cost for the position will be mitigated down to $5268.00.  You can then sell the June 2011 $60 strike calls (or any strike, or any expiration).  If the QQQ does rise above $60, your total cost of $5268 will be recovered, PLUS any amount up to $60, in this hypothetical case, $6000-$5268, for a very decent return.