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Buying Calls
Because options are such a versatile
investment, there are numerous strategies for using them to advantage. Below are some
basic strategic concepts. To learn about more complex options strategies, you may want to
discuss using options with a broker or other financial professional.
Two Ways to Benefit from Stock Price
Increases
If you buy a call option - the right to buy 100 shares at the specified strike price - and
the market price of the underlying stock rises above your strike price, you have two
options.
- Exercise the option to buy the stock at
your strike price and, at the same time, sell the stock on the stock market for the
current market price. Your earnings will be the difference between the market and strike
price - less the premium you paid to purchase the call option.
- Or, assuming the premium for the option
has also gone up during this time period, you can simply sell your options contract and
collect the difference between the premium you paid at purchase and the proceeds you
receive upon the sale.
Using Calls as Part of a Balanced
Investment Plan
A strategy called the "90/10" strategy involves dividing your available
investment funds between call options (90%) and another money market instrument (10%) such
as T-bills. This enables the investor to benefit from the call options when stock prices
rise (see examples above) but provides some protection if prices drop. If stock prices go
down, and the options expire worthless, he or she can at least help to cover the lost
premium with earnings from the money market investment.
Locking in Your Stock Price
What can you do when you want to buy some stock but don’t have the cash? If the price
looks good but you’re short on funds, buying a call keeps your options open - to
purchase the shares at the price you want at any time before the options contract expires.
Insurance for Short Sales
This strategy is employed by investors who sell short. This means selling stock that the
seller does not own. Investors would sell short when they expect that the stock price will
go down and they wish to profit by buying the stock at a lower price at a later date.
But what happens if the stock price
doesn’t go down later, or even goes up? The investor who sold short may have to buy
some very expensive stock to fulfill the obligation to sell short. But, this investor can
get some protection from possible loss by purchasing call options at a fixed strike price
to close out the short stock position. This is called hedging.
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