Credit: Shutterstock photoAmid these uncertain market conditions, trading options allows sophisticated investors to profit from - and even hedge against - the ups and downs of the market. Though most media accounts of late have dwelt on the recent struggles plaguing Wall Street, options players are still making money. However, while the profit potential is virtually unlimited, these complex securities don't come without risks. In order to be successful in your options-trading venture, one should first become familiar with some basic strategies.
In today's edition of Options Basics , we're going to delve into the exciting world of calls .
First, what is a call option? Simply put, a call gives the buyer the right (not the obligation) to purchase an underlying security at a set price (strike) before a certain time (expiration). Each contract generally represents 100 shares of the stock. Depending on the current share price of the stock, options are available in various strike prices. On that same note, options buyers can purchase contracts for a variety of months, with each option expiring on the third Friday of that month.
Buying a call is the most basic options-trading strategy that you can utilize. There are two primary objectives for purchasing a call: to profit from an increase in the price of the underlying security, or to lock in a good purchase price for the stock. Call buyers are usually bullish on the stock, and expect the price of the underlying security to rise above the strike price before the option expires. In other words, by purchasing a call, you're essentially saying that you believe the underlying stock's value will increase before the option's expiration date.
For example, let's say that you've been following XYZ Corp. ( XYZ ), and you think the shares are going to rise in the near-term. More specifically, although XYZ is currently flirting with the 95 level, you're confident that the stock will muscle past the 100 level by June expiration. With this in mind, you could purchase an XYZ June 100 call for a premium, which is the total cost of an option contract. (The premium isn't fixed and changes constantly, depending on what buyers are willing to pay and what sellers are willing to accept for the option.) In this example, let's say the premium for an XYZ June 100 call is $2, which would make your total initial investment $200 ($2 x 100 shares).
Now, let's pretend that it's late May, and XYZ is already trading at 105 - surpassing your initial predictions. Your call option is now considered "in-the-money," which is when the share price is above the stock price. You now have three routes to choose from: close your position, exercise the option, or let it ride.
By closing your position, you would sell your option at the current market value (the new premium), which should net a pretty profit. For example, if the new premium for a June 100 call is now $5, you would stand to gain $300 ($5 x 100 = $500, minus the initial premium of $200). You could also make money by exercising your position - which, in this case, would consist of purchasing 100 shares of XYZ at $100 (the strike price), then selling the stock back in the market at $105 (the current share price). By letting it ride, you would hold on to your call a little while longer to see if you can extend your gains.
(For the sake of simplicity, none of these calculations include a brokerage commission. But in the real world, you'll have to calculate their impact on your trading. Any purchase of a stock or an option will involve a brokerage commission. The amount may be small, but it will make a dent in your profit. And generally, a commission is charged on each leg of a trade: the purchase of calls; the sale of calls; the purchase of stock; the sale of stock. In the example above, the apparent greater profit of exercising your position might be offset by greater brokerage commissions.)
In this example, let's assume that you let it ride. In the meantime, the shares of XYZ have taken a nosedive in the wake of the company's weaker-than-expected earnings report, and are now hovering near $90. In order to break even on this investment, you would need the equity to hit $102 (which is the strike price + the premium paid) before options expiration. If the stock fails to rally to this level before the expiration date, the contract will expire worthless. In this worst-case scenario, the call buyer has lost his initial investment of $200.
However, this brings me to one of the primary benefits of call buying: your potential risk is limited to the premium paid. Let's backtrack and say that you were bullish on XYZ when it was trading near $95, but opted to purchase 100 shares of the stock instead of buying a single June 100 call position. At $95, your initial investment would've cost you $9,500 - compared to the initial investment for the call option, which was only $200.
Under the same circumstances noted earlier, let's pretend that the shares of XYZ dipped lower in the following months, falling to the $90 level. By owning the stock instead of the call option, you've lost $500, as your 100 shares of XYZ are now only worth $9,000.
In conclusion, buying calls allows investors to profit from a stock's gains by putting fewer dollars at risk. Furthermore, a call buyer's gains are virtually unlimited, while his maximum loss is limited to his initial investment. While this options-trading strategy isn't without its risks, buying calls can often give sophisticated traders greater leverage than purchasing stocks or funds outright.
Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
All Rights Reserved. Unauthorized reproduction of any SIR publication is strictly prohibited.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
