Buying call options is a bullish strategy using leverage and is a risk-defined alternative to buying stock. Foregoing the abstract "call options give the buyer the right but not the obligation to call away stock", a practical illustration will be given:
- A trader is very bullish on a particular stock trading at $50.
- The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
- The trader expects the stock to move above $53.10 in the next 30 days.
Given those expectations, the trader selects the $52.50 call option strike price which is trading for $0.60. For this example, the trader will buy only 1 option contract (Note: 1 contract is for 100 shares) so the total cost will be $60 ($0.60 x 100 shares/contract). The graph below of this hypothetical stock is given below:
There are numerous reasons to be bullish: the price chart shows very bullish action (stock is moving upwards); the trader might have used other indicators like MACD (see: MACD), Stochastics (see: Stochastics) or any other technical or fundamental reason for being bullish on the stock.
Options Offer Defined Risk
When a call option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in this example, $60. Whether the stock falls to $5 or $50 a share, the call option holder will only lose the amount they paid for the option. This is the risk-defined benefit often discussed about as a reason to trade options.
Options offer Leverage
The other benefit is leverage. When a stock price is above its breakeven point (in this example, $53.10) the option contract at expiration acts exactly like stock. To illustrate, if a 100 shares of stock moves $1, then the trader would profit $100 ($1 x $100). Likewise, above $53.10, the options breakeven point, if the stock moved $1, then the option contract would move $1, thus making $100 ($1 x $100) as well. Remember, to buy the stock, the trader would have had to put up $5,000 ($50/share x 100 shares). The trader in this example, only paid $60 for the call option.
Options require Timing
The important part about selecting an option and option strike price, is the trader's exact expectations for the future. If the trader expects the stock to move higher, but only $1 higher, then buying the $52.50 strike price would be foolish. This is because at expiration, if the stock price is anywhere below $52.50, whether it be $20 or $52.49, the call option will expire worthless. If a trader was correct on their prediction that the stock would move higher by $1, they would still have lost.
Likewise, if the stock moved to $53 the day after the call option expired, the trader still would have lost all their premium paid for the option. Simply stated, when buying options, you need to predict the correct direction of stock movement, the size of the stock movement, and the time period the stock movement will occur; this is more complicated then stock buying, when all a person is doing is predicting the correct direction of a stock move.
Call Options Profit, Loss, Breakeven
The following is the profit/loss graph at expiration for the call option in the example given on the previous page.
The breakeven point is quite easy to calculate for a call option:
- Breakeven Stock Price = Call Option Strike Price + Premium Paid
To illustrate, the trader purchased the $52.50 strike price call option for $0.60. Therefore, $52.50 + $0.60 = $53.10. The trader will breakeven, excluding commissions/slippage, if the stock reaches $53.10 by expiration.
To calculate profits or losses on a call option use the following simple formula:
- Call Option Profit/Loss = Stock Price at Expiration – Breakeven Point
For every dollar the stock price rises once the $53.10 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock gains $5.00 to $55.00 by expiration, the owner of the the call option would make $1.90 per share ($55.00 stock price – $53.10 breakeven stock price). So total, the trader would have made $190 ($1.90 x 100 shares/contract).
If the stock price increased by $2.75 to close at $52.75 by expiration, the option trader would lose money. For this example, the trader would have lost $0.35 per contract ($52.75 stock price – $53.10 breakeven stock price). Therefore, the hypothetical trader would have lost $35 (-$0.35 x 100 shares/contract).
To summarize, in this partial loss example, the option trader bought a call option because they thought that the stock was going to rise. The trader was right, the stock did rise by $2.75, however, the trader was not right enough. The stock needed to move higher by at least $3.10 to $53.10 to breakeven or make money.
If the stock did not move higher than the strike price of the option contract by expiration, the option trader would lose their entire premium paid $0.60. Likewise, if the stock moved down, irrelavent by how much it moved downward, then the option trader would still lose the $0.60 paid for the option. In either of those two circumstances, the trader would have lost $60 (-$0.60 x 100 shares/contract).
Again, this is where the limited risk part of option buying comes in: the stock could have dropped 20 points, but the option contract owner would still only lose their premium paid, in this case $0.60.
Buying call options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page.
Downside of Buying Call Options
Take another look at the call option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $53.10 is.
Call Options need Big Moves to be Profitable
Putting percentages to the breakeven number, breakeven is a 6.2% move higher in only 30 days. That sized movement is possible, but highly unlikely in only 30 days. Plus, the stock has to move more than that 6.2% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of buying 100 shares outright and buying 1 call option contract ($52.50 strike price) will be given:
- 100 shares: $50 x 100 shares = $5,000
- 1 call option: $0.60 x 100 shares/contract = $60; keeps the rest ($4,940) in savings.
If the stock moves 2% in the next 30 days, the shareholder makes $100; the call option holder loses $60:
- Shareholder: Gains $100 or 2%
- Option Holder: Loses $60 or 1.2% of total capital
If the stock moves 5% in the following 30 days:
- Shareholder: Gains $250 or 5%
- Option Holder: Loses $60 or 1.2%
If the stock moves 8% over the next 30 days, the option holder finally begins to make money:
- Shareholder: Gains $400 or 8%
- Option Holder: Gains $90 or 1.8%
It's fair to say, that buying these out-of-the money (OTM) call options and hoping for a larger than 6.2% move higher in the stock is going to result in numerous times when the trader's call options will expire worthless. However, the benefit of buying call options to preserve capital does have merit.
Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Buying call options and continuing the prior examples, a trader is only risking a small 1.2% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss of 5% is easier to take for an option call holder than a shareholder:
- Shareholder: Loses $250 or 5%
- Option Holder: Loses $60 or 1.2%
For a catastrophic 20% loss things get much worse for the stockholder:
- Shareholder: Loses $1,000 or 20%
- Option Holder: Loses $60 or 1.2%
In the case of the 20% loss, the option holder can strike out for over 16 months and still not lose as much as the stockholder. Moreover, the stockholder now has to make over 25% on their stock purchases to bring their capital back to their previous $5,000 level.
Moral of the story
Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options have many variables. In summary, the three most important variables are:
- The direction the underlying stock will move.
- How much the stock will move.
- The time frame the stock will make its move.