Understanding Call Buying

Using options to diversify – and protect – your portfolio

Oct 17, 2014 at 11:17 AM
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The stock market can go up or down in an instant. You may think you have a firm grasp on what the market is going to do next, but the truth is, it's impossible to predict what's ahead. The smartest investors are the ones who have strategies in place to take advantage of -- and protect against -- whatever the market throws their way.

Trading options is one investment strategy traders use to benefit from both bullish and bearish markets, volatility and stagnation. Though options trading can seem complicated at first, Schaeffer's can show you the basics to get you started on your path to a more diversified portfolio.

Below, we'll be discussing one type of option strategy -- call buying -- to help you capitalize on (or hedge against) a stock's upside move.

What is a Call Option?

A call option is a contract that gives you the right, but not the obligation, to buy 100 shares of a security at a certain price. A call is "in the money" if the underlying stock is trading above a predetermined price -- known as the "strike price."

If a call moves in the money, the buyer can exercise the option, meaning they can buy the shares at a discount to market value. Another strategy is to sell to close the call. When you sell to close a call, you simply collect the profits from the option contract, since it has increased in value since you bought it. The buyer would need to do this prior to the option's "expiration date" -- the date at which the option ceases trading.

There are more possibilities than ever when it comes to option expiration dates, thanks to the relatively recent addition of weekly options, which expire at the close on various Fridays. Standard monthly options expire at the close on the third Friday of every month, while Long-Term Equity AnticiPation Securities (LEAPS) allow traders to place bets two-plus years into the future. Keep in mind, though -- the more time you need for your move to pan out, the more expensive your option will be, as a LEAPS contract has more "time value" than a weekly or monthly option.

Why Would Someone Buy A Call?

The most straightforward reason to buy a call is if you feel an equity's price is going to move higher. If you believe a stock will move above $80 within a certain time frame, you could buy an 80-strike call in a corresponding series -- that is, an option that expires around or after the anticipated move in the underlying. If your predicted move comes to fruition, your call will move into the money, and you can either exercise your option to buy the shares at $80 apiece, or you can sell to close the call to cash in on higher premiums.

Another reason to buy a call is to hedge a short stock position. As a short seller, your primary goal is for the shares to go lower, but you're wary of a short-term rally. Not wanting to abandon your short position, you might purchase call options as a type of insurance to lock in an acceptable exit price, should the security move against you.

Advantages to Call Buying

There are a couple of clear benefits to buying call options instead of simply buying shares in an equity. The most glaring advantage is, with options, your risk is smaller, while your gains are theoretically unlimited. If you bought shares in a stock, your potential losses could be huge, since the stock could go to zero. But, if you decided to purchase a call instead, your losses would be limited to the premium you paid for the contract. So, even if the stock price drops to zero, you'd only lose the premium paid for the contract, nothing more.

How It Works

Let's say you've been following the imaginary ticker XYZ, which is trading at $110. XYZ has earnings coming up in early November, and you believe the numbers will be strong, sending shares of XYZ above the $110 mark. Therefore, you're eyeing the November 110 call, which expires at the close on Friday, Nov. 21. The ask price for that option is $3.50. Now, each option contract controls 100 shares, so you'd pay $350 for one contract (we're figuring without commission, for simplicity's sake).

Outcome A: XYZ's earnings are a success, and as a result the shares rally, increasing all the way to $120 -- nice! You can sell to close the option (now worth $10) at expiration for $1,000 (x 100 shares), based on 10 points of intrinsic value. Since you paid just $350 for your contract, your profit would be $650 (minus commission). That's a 185% return on your investment.

Instead of selling to close, you could exercise the option, meaning you'd buy the shares of XYZ for a discount ($110 apiece, compared to Street value of $120). However, this will require you to pay more brokerage fees, thus most traders simply take the profit by selling to close the option.

Outcome B: XYZ earnings are a disaster, and the stock subsequently stumbles to $100. Now, you can simply allow the option to expire worthless, meaning all you lose on your investment is the $350 you paid for the option.

Considering the outcomes above, let's see how buying a call option compares to simply buying shares of a stock.

Say instead of buying the November 110 call you decided to buy 100 shares of XYZ at $110 apiece, or $11,000 -- a much heftier initial investment than the call buyer. Again, assuming XYZ jumped to $120 post earnings, you'd see a $10 profit per share, or $1,000 total. However, with all the variables kept the same, you'd only end up with a 9% return on your investment. Essentially, you risked $11,000 to make $1,000, whereas with the call option, you only risked $350 and made $650, if you sold to close the option.

Conversely, if XYZ shares fell to $100, you'd be out $10 per share, or $1,000 total, right off the bat, and lots of capital still tied up in the stock. Compare this to the $350 you'd have lost if you'd simply bought the call option, and it's clear how options provide more bang for your buck.


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