Beginning Option Strategies/Bullish Strategies

The Basics of Buying Calls
Andrea Kramer (akramer@sir-inc.com)

This article analyzes the most elementary form of options trading: buying calls.

What is a call? Simply put, a call gives the buyer the right (not the obligation) to purchase an underlying security at a predetermined price (strike) before a certain time (options expiration). Each contract generally represents 100 shares of the stock, with options available in a variety of strike prices and expiration dates.

Who should tune in? Buying calls is best suited for bullish investors expecting the underlying stock to make a move higher on the charts. The two primary objectives of this simple strategy are: to profit from an increase in the stock price, and, thus, the callís value; or, to lock in a good purchase price for the stock.

How does it work? First, the investor would single out a stock with the potential to move higher. Next, the trader would determine his or her specific forecast for the security, including how far and how long he or she expects the shares to rise. The distance higher should correlate with the callís strike price, while the length of the predicted rally should mimic the callís expiration date. For instance, the investor anticipating a fast and aggressive move in the underlying stock would probably purchase a higher-strike call with a shorter life span than that of the investor expecting a slow and steady move higher over the next few months.

Whatís in it for me? The goal of this strategy is for the underlying shares to surpass the call strike by options expiration. The callís value will increase with each step above the strike price, meaning the maximum potential profit is theoretically unlimited. In other words, when the stock finishes higher than the strike price at options expiration, the call will be worth more than the original purchase price.

Call buying is also considered an appealing alternative to buying shares of the stock outright. By purchasing a call, the investor can capitalize on a stockís journey higher without sacrificing as much cash as the stock buyer.

What do I have to lose? Another primary advantage to buying calls is the limited risk potential. If the shares of the underlying stock fail to breach the callís strike by expiration, the investorís losses are limited to the initial premium paid for the call.

In order to avoid a loss on the play, the trader needs the underlying equity to finish at or above the breakeven level, which is calculated by adding the strike price to the premium paid.

(Donít forget to include any brokerage fees or commission costs.)

Letís look at an example

Meet Agatha, a novice option trader with her eye on stock XYZ. The equity is currently flirting with the $50 level, but Agatha thinks the shares will surpass the $55 level by October options expiration. As such, she purchases the XYZ October 55 call for a premium of $1, or $100 (x 100 shares).

In order to break even on the position, Agatha needs the shares of XYZ to muscle past the $56 level (strike + premium paid) before October-dated options expire. If XYZ fails to breach this level, Agatha will forfeit the $100 paid to initiate the purchase.

Theoretical call purchase on stock XYZ

On the other hand, letís assume the shares of XYZ rally to the $60 level before October options expiration. The October 55 call would be five points in the money, making the optionís intrinsic value $5. By closing the position, Agatha would sell her call at the current market value ($5, or $500). Compared to the $100 she originally paid for the call, and her position would net a profit of $400.

Or, if Agatha is interested in owning shares of XYZ, she could exercise her October 55 call instead. In other words, she could buy 100 shares of XYZ at $55 apiece (the strike price), or $5,500 total, which is less than the $60, or $6,000 total, she wouldíve paid to buy the stock at the current market price.

In conclusion

Call buying is the most basic option-trading strategy, utilized to profit from a stockís upward trajectory. While the risks of this simple option play are limited, there are a few things traders should keep in mind before embarking on their call-buying journey.

First, remember to determine your specific expectations for the underlying equity before buying a call, in order to maximize your profit potential. Also, while purchasing calls is an appealing alternative to buying shares of the stock outright, shareholders, unlike call holders, are entitled to dividends.

Finally, remember that every option trader experiences a losing position at one time or another. The trick is to minimize those losses by being proactive. After purchasing your call, donít hesitate to close your position if you think the underlying stockís journey into the black has run its course. Hoping for a miracle wonít get you anywhere, and will likely only exacerbate the problem.




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