Monday, January 15, 2007

A Little About Call Options

While many of our readers only trade stocks, I thought it might be helpful to write a bit about options, specifically call options. I often use call options in my Option Trader trades and my own portfolios, so I thought it might add some clarity if I provide some explanations of certain basic options strategies. At the risk of boring some of the more sophisticated traders, I'll start by defining options and call options in particular. I'll then take a look at buying calls as a directional strategy. If the readers are interested, I'll look at other strategies using calls and, later, puts in subsequent articles.

Options are quite simply *contracts*. One party to the contract pays a premium and obtains some kind of right. That person is the buyer of the option. The other party to the contract receives the premium the buyer pays and takes on some kind of obligation. In the case of a call option, the buyer pays a *premium* and, for that premium, the buyer obtains the right (but does not have the obligation) to buy the *stock* at the agreed price (the *strike price*) anytime before *expiration* (in the case of American style options). We can see several terms in the preceding sentence that require some explanation.

An option *contract* usually controls 100 shares of stock. Note I said "usually." Sometimes it may control a different number so the trader always needs to check.

The *stock* is also known as the underlying. Options deal with a specific underlying so one of the elements in buying or selling an option is what is the underlying.

The *strike* price (also known as the "strike" or the "striking price") is the price at which the buyer of a call has the right to buy it and the price at which the seller of a call is obligated to sell the stock if called (also known as assigned). In other words, if the owner of a call *exercises the option *(calls the stock) he is buying the stock at the agreed strike price and the seller must sell him the stock at that price if the option is exercised before expiration. For American style options (most stocks with options are American style), expiration is noon on the Saturday following the third Friday of the month. For practical purposes that means they expire at close of trading on the third Friday of the month since we can't trade on Saturdays. As you can see, options *expire.* That means that the buyer no longer has the right to buy the stock at the strike price and the seller no longer has an obligation to sell at the strike price. The call buyer who did not exercise his options and buy the stock at the strike price before expiration loses the premium he paid and the seller of the call keeps the premium and no longer has any obligation after expiration. The *premium* is the amount paid by the call buyer to the call seller (for the right obtained by the buyer and the obligation undertaken by the seller). Premiums consist of one or two elements. One of those elements is *time value*. Since the buyer of our call option is obtaining the right for some period of time, he will be paying for that element. Generally, the more time one buys (the farther out the expiration), the higher the time value will be.

Now that we've seen the elements that make up options, let's look at a concrete example to try to gain some clarity. As I write this piece, Waste Management (WMI) is trading right around 35. Suppose I am bullish on WMI. Of course, I could buy the stock and profit if it went up. I could also consider buying some call options since I would expect the price of those options to go up as the stock went up. I am writing this in June and I see that the *October* (that means they expire on the third Friday in October) *35* (that's the strike price) calls are trading at $1.80 x $1.90. So, for example, I could buy 1 contract of the Oct 35 calls for $190 (that's 100 shares times the $1.90) plus commission. That is what is known as an "at the money" call. I am buying the strike that is the same price at which the stock is currently trading, i.e. 35. All I am paying for is time. If the stock stays at 35 until the third Friday in October would my option be worth anything? No, I have the right to buy the stock at 35 but that's all it is selling for on the market so there is no advantage. However, let's say the stock went to $50 early October. What would my 35 call option be worth then? Well, I have the right to buy the stock for $35 a share and I could turn around and sell it for $50 so my option would be worth at least $15 plus some time value until expiration. That $15 is *intrinsic value* and the option is then what is known as "in the money." So now we can see that call options that are "in the money" are options whose strike price is less than the price at which the stock is trading. Those options have both intrinsic value and time value. An option is "at the money" when the price of the stock and the strike price are essentially the same. Premiums for "at the money" options are all time value. Finally, one can also buy out of the money options. In the case of a call, "out of the money" options are those whose strike is greater than the actual price of the stock. Again, when buying "out of the money" options, the trader is paying for only time value. "Out of the money" options are always cheaper than "in the money" options or "at the money" options because there is less liklihood that they will have any intrinsic value at expiration. In fact,one of the common mistakes novice traders make is to buy short term out of the money options because they are cheap. Folks, they are cheap for a reason.

Many novices believe that traders buy call options with the ultimate intent of exercising them by purchasing the stock. Ordinarily, that is not what is done. The call buyer is looking for a move up in the stock price. If the stock price moves up, the price of the call is also expected to move up. If that happens, the call buyer can profit simply by selling the call. Let's take a theoretical example of XYZ stock trading at $35 a share. Suppose it's June now and we think XYZ is going up so we decided to buy the Oct 35 calls for $1.50. We buy 10 contracts and pay $1500 (10 contracts x 100 shares per contract x $1.50 a share) plus a commission. We want the stock to go up. Let's say it runs up to $40 in a couple of weeks. Now, our Oct 35 calls are $5 in the money and have that $5 intrinsic value, but there is also time left so they will have some time value in addition. Suppose the time value is $0.80. Now we can sell our calls for $5.80 and bring in $5,800 (selling 10 contracts x 100 shares per contract x $5.80 a share) less a little commission. Now we have a profit of $5,800 minus our original $1,500 investment or a profit of $4,300. That's a 286% return. What was our risk? It was our original investment of $1,500. Even if the stock went to zero, we couldn't have lost more than we paid for the calls in the first place plus commissions. Compare that to the stock purchase. If we bought 1000 shares of the stock at $35, we'd have $35,000 invested (half that on margin) and our whole $35,000 would be at risk. If the stock moved $5 to $40 a share and we sold it, we would make $5,000 less commission, and that would only be a 14% return. Let's see, which is better, risking $1,500 and getting a 286% return or risking $35,000 and getting a 14% return? Of course, it isn't all that easy or clear. When we bought the call option, we knew it would expire. Time is running against us. We need the stock to go up and to go up fairly soon, certainly before expiration, if we are to profit.

Buying calls is a bullish strategy. The following is reprinted from the CutLoss Level One Training Manual © with the permission of the author (me):

"Instead of buying stock if we are BULLISH, we might buy CALLS on the stock. Some of the advantages of buying CALLS:
-If we're right on the direction and the stock moves fairly quickly, we profit quickly
-Risk is limited to what we paid for options
-We can play higher priced stocks without committing so much money to the trade
-If successful, our percentage return will be higher
-We can control more shares of stock with less money (leverage)

Some of the disadvantages of buying CALLS:
-We can lose some or all of our investment if the stock doesn't move in the direction we anticipated in a relatively short period of time
-The time value of the option erodes as time passes making the option less valuable
-We will lose money if we are wrong about the direction of the stock's movement."

As time goes on, I plan to include articles on various other option trading including writing covered calls, vertical credit and debit spreads, selling naked puts, and horizontal and diagonalized spreads. I'm not going to make this an options column so these will be interspersed with other articles of a more general nature.

Bill Kraft, Editor
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