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Basic
Strategies for Options - Buying Calls
Buying
a call option gives the holder the right, but not the obligation
to buy a specified underlying security at a specified price for a
fixed period of time. There
are two very good reasons why an investor would chose to buy a
call option.
Participate
in an Anticipated Rally
The
right to buy a security at a fixed price can be a very valuable
right if the underlying stock price is rising. Remember that one of the principle benefits of options is
leverage. By fixing
the price to be paid for the underlying security the option buyer
gains tremendous leverage.
Let's
return to our example featuring IBM Corp. (IBM). We will assume that IBM is trading at $100 and the IBM
November 100 call is trading for premium of $2. If an investor is bullish for IBM she may decide to buy
this at-the-money call option. Her out of pocket cost is $200 but she now controls 100
shares of IBM for a fixed period of time.
Let's
also assume that she is correct about the direction of the stock
price and during the life of her option contract IBM rallies to
$105. The right to
buy IBM common stock at $100 is suddenly more valuable, the IBM
November 100 call has moved from being at-the-money to in-the-money, the option increases to $5.
Our
astute investor can now do one of two things to realize her
well-deserved profit.
1. Exercise her option and buy 100 shares of IBM common stock
for $100 per share for a capital outlay of $10,000 and
simultaneously sell 100 shares of IBM in the market at $105 for
net proceeds of $10,500. If
we subtract her cost for the IBM November 100 calls ($200) she
earns a tidy profit of $300.
2. Sell the IBM November 100 call in the open market.
The option is now in the money and should command at least
$5 per contract or $500. If
we subtract the initial cost of the contract ($200) she earns a
profit of $300, or a gain of 150 percent on the original modest
investment.
As
you can see, it makes little sense for our investor to exercise
her right to acquire the common stock at $100 unless she wishes to
hold a position in IBM common stock after the expiration. Exercising the option would incur a commission cost
and put
her modest profit at risk.
If
our investor is incorrect about the direction of IBM common stock
her option is likely to decline to zero resulting in a 100 percent
loss of investment.
Hedge
a Short Position
Short
selling common stock is the practice of selling a borrowed stock
in the open market in anticipation of having the opportunity to
buy back the common stock later at a lower price. An investor might take such action when he believes the
common stock is likely to decline significantly.
Here
is the rub, short selling requires a margin account and margin
calls may occur if the common stock rises in price. The investor will be forced to either deposit additional
funds to cover the margin call or liquidate the short position.
Buying
a call option gives the short seller greater flexibility and
protects against losses. Consider
this example.
Our
short seller is certain that IBM Corp. (IBM) common stock is
likely to fall significantly in price so he borrows 100 shares and
sells this position in the open market at the current price of
$105. The proceeds of
this sale are $10,500. This
money is deposited in this account. To protect this position our short seller decides it would
be a very good idea to buy a call option as protection. He buys one IBM November 105 call for a premium of $2 for a
cost of $200. Now let's run through the possibilities.
1. If our short seller is correct and IBM common stock sinks
to a price of $90 by the expiration date of his call option this
position becomes worthless – after all the right to buy IBM
common stock at $105 will not find many buyers when the stock can
be bought in the open market at $90. His short position in IBM is now $15 in his favor, a tidy
profit. At this point
he may choose to collapse the entire strategy and yield a profit
of $1300 ($10,500 proceeds for the short sale less the cost of the
IBM November 105 calls ($200) less the cost of buying IBM common
stock at $90 ($9,000)).
2. Our short seller is dead wrong and IBM common stock rallies
to a price of $115. This
is not good because our short seller was hoping to buy back IBM
common stock at a lower price. The short position is now unprofitable by $10 or $1,000 so
it was a good thing he bought that IBM November 105 calls as
insurance against a potential rise in price. Our short seller exercises his right to buy IBM common
stock at $105 to cover his wayward short position and realizes a
net loss of just $200 ($10,500
proceeds for the short sale less the cost of the IBM November 105
calls ($200) less the cost of buying IBM common stock at $105
($10,500)). By using
options to hedge his short position our short seller limited his
loss to the cost of the premium paid versus a potential loss of
$1,000 without the option strategy.
The
maximum potential loss in this strategy is limited to the cost of
the call plus the difference, if any, between the call strike
price and the price received for the short stock. It is noteworthy
that profits are also decreased by the cost of the call.
basic
strategies 
selling puts
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Strategies > Buying Calls
