Buying a call option is 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.
Calls grant you the right, but not the obligation, to buy stock.
Puts grant you the right, but not the obligation, to sell stock.
Buy – right
Sell – obligation
Buy – right
Sell – obligation
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: Options are listed in strike prices at specific intervals, depending on the underlying stock price.
- Options are said to be wasting assets because they have expiration dates.
- Stock prices are listed as for a single share of stock.
- Each option controls 100 shares of stock.
- The price of an option is comprised of intrinsic and time value.
- 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.
ITM – $30
ATM – $30.78
OTM – $33
ITM – $33
ATM – $30.78
OTM – $30
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 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. Of course, if MSFT rises much higher than your $33 strike price, you would profit much more by exercising your $33.00 option.
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.
Stock must move in a timely manner: 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. That is why I do not buy call options.