Stocks quoted in this article:
Google Inc (NASDAQ:GOOG) and Priceline.com Inc (NASDAQ:PCLN) have garnered their share of positive press lately for becoming the first-ever names in the S&P 500 Index (SPX) to surpass the $1,000 level. While this is a mental victory for existing shareholders, it leaves many sidelined investors wondering … how can I ever afford a piece of that stock? After all, 100 shares of Google at its current price would cost around $102,275 (give or take).
Well, you could wait around for the stock to split, which has been a long time coming. Or you could consider participating in the stock's upside via the long call strategy.
Purchasing a call option gives you the right to buy shares of the associated stock at a predetermined level (the "strike" price) on or before a specific date (the "expiration" date). Now, traders don't have to buy the stock -- after all, that is what you are trying to avoid! But the options themselves, as derivatives of the stock, can also be a profitable trading tool.
Let's check out a hypothetical example, assuming you are bullish on Google at its current price of $1,022.75.
You could spend what amounts to two years of tuition (plus room and board!) at Harvard University on 100 Google shares. Or, you could buy the January 2014 1,025-strike Google call for $31.85, or a total net debit of $3,185 (as the contract represents the theoretical control of 100 shares). This position gives you the right to purchase GOOG shares for $1,025 at any point between the time the trade is opened and the time the option expires -- which happens to be Jan. 17, 2014 -- as long as the stock is trading above the strike price.
If Google continues to advance, the potential profit on the call is theoretically unlimited. If GOOG moves to $1,080, for example, the 1,025-strike calls are worth $55 in intrinsic value, or $5,500. That's a profit of $2,315, or roughly 73%, after subtracting the premium needed upfront. Buying the stock, on the other hand, would have yielded a profit of $5,725, but on a percentage basis, that's just 5.6%. Note that long calls are not profitable at expiration unless the stock is above the breakeven point (the strike price plus the premium paid) -- being north of the strike isn't good enough to realize a profit, but it does prevent a 100% loss.
Losses when buying call options are, however, capped at 100% of the premium paid. Even if Google were to drop all the way to zero (perish the thought!), you would only be out the initial $3,185.
There are even mini options on GOOG and four other names, which control 10 shares (instead of the typical 100). Generally speaking, these require only a fraction of the upfront premium as their traditional counterparts. For example, the January 2014 1,025-strike call mini, priced at $32.00, would cost an investor just $320 (the premium times 10 shares).