The outright purchase of an option is the simplest type of option trade for most traders to understand, and some prefer to go no fur- ther. When we say “outright,” we are referring to an option purchase that is not hedged by anything else, such as the sale of a similar option or the sale of stock. In the preceding example, the purchase of the XYZ July 50 call for 3 has several definable qualities that are fairly easily understood by most traders. First, the cost of one option is $300, and that is the most that can be lost. Second, the break- even point at expiration is 53 (plus commissions), for a call option is always worth at least the difference between the stock price (53) and the striking price (50). Third, nearly unlimited profits are available, for the option will appreciate in price as long as the underlying stock, XYZ, continues to rise in price.
This is typically felt to be an aggressive strategy, because the leverage is so high. You can lose all your money in a fairly short amount of time if the option expires worthless. In the preceding example, if the stock drops at all from the price of 50 (where it was trading when the option was purchased) by expiration, the option will expire worthless, and the trader will lose the $300 he paid for the call. Leverage works both ways, of course, and thus huge per- centages are possible as well. For example, if the stock were to advance by only 20 percent (from 50 to 60), then the option would be worth $1,000. So the stock trader would make 20 percent, while the option trader would make 233 percent ($300 becomes $1,000) from the same stock movement.
Before discussing option buying in more detail, let’s look at an example of a put purchase. Since the put gives the holder the right tosell the underlying strike at the striking price (up until the expira- tion date), this is a bearishly oriented strategy. The put option will
appreciate in value if the stock falls and will lose value if the underly- ing stock rises in price.
Example: Suppose that XYZ common stock is trading at 50, and the XYZ July 50 put is selling for 2, or $200. The profit table and profit graph (Fig- ure 2.2) are shown below.
At July Expiration
Stock Net
Net Put Result
Price Price ($)
30 20 +1,800
35 15 +1,300
40 10 +800
45 5 +300
50 0 –200
55 0 –200
Figure 2.2 PUT PURCHASE
Figure 2.2 shows that this position has a limited loss on the upside and can make very large profits on the downside.
Many experienced traders prefer option purchases to stock pur- chases, however, because they feel that if they can pick a reasonable percentage of trading winners—perhaps only 30 percent or 40 per- cent—the leverage provided by the winning trades will outweigh the more frequent but limited losses incurred by the losing trades. The key in such a strategy is to be able to let profits run when they occur.
Buying options is often regarded as one of the most speculative trading activities. However, there are often differing ways in which to establish a strategy. These differing ways may change the speculative to the conservative, or at least moderate things somewhat.
Before actually discussing the type of option you should pur- chase, it must be stated that the outlook for the performance of the stock is of utmost importance. If the underlying stock drops in price, you are not going to profit from a call option purchase, no matter which call you buy.
The main attraction for buying options—at least to the average or novice trader—is the leverage that is available. You can put up a fairly small amount of money (a couple of thousand dollars) and make returns in the 200 percent or 300 percent area. Of course, you can lose 100 percent fairly quickly as well.
In this regard, many novice traders buy out-of-the-money options in order to keep their cost down. They then dream of huge potential returns, but these returns are usually attainable only if the stock can make a rather large percentage move. To make matters worse, the typical buyer of out-of-the-money options buys options that have too short a life span—he does not give the stock enough time to make the large move that is required.
Over the years, I have spoken to numerous stock traders who have given up on options. They feel that they can make money trad- ing stock but always seem to lose when options are concerned. Their problems generally result from one mistake: buying too far out-of- the-money.
Professional stock traders often use options for one purpose only: to reduce their required investment in a position. They are not
attempting to capture huge leveraged returns; rather, they are merely using the option as a substitute for the stock itself. In order to create an option position that is virtually the same as a stock position, you should buy in-the-money options, probably with little time remain- ing.Moreover, if a professional normally trades 2,000 shares of stock, then he would probably buy 20 in-the-money calls; he does not usually attempt to leverage the quantity—the leverage is in the price.
By buying in-the-money options, you are minimizing the amount of money spent for time value premium. Time value premium is the part of an option that wastes away as time passes. Out-of-the-money options are entirelycomposed of time value premium. In-the-money options may have little or sometimes even no time value premium.
Also, the in-the-money option will most closely match the perfor- mance of the underlying stock on a day-to-day basis. If the stock is up a point, the in-the-money call option will probably rise in price by at least three-quarters of a point or more. The out-of-the-money option may not move much at all. Of course, this fact could work against the call option holder if the stock moves downin price. That is why we originally stated that stock selection is of the utmost importance. An example may be helpful.
Example: Suppose that you have decided that XYZ is a good stock to buy for a short-term trade, and the stock is selling for 19 per share. If today were the first trading day of the year, which option would you buy?
Call Option Offering Price
Jan 15 4
Jan 171⁄2 2
Jan 20 1⁄2
March 171⁄2 21⁄2
March 20 11⁄8
March 221⁄2 1⁄2
The professional stock trader would buy either the Jan 15 call (which has no time value expense at all) or the Jan 171⁄2call (which has a half point of time value, but is 11⁄2points in-the-money and will move upward quickly if the stock advances).
The novice would be more inclined to buy the cheapest options (either the Jan 20 or the March 221⁄2, both trading at 1⁄2) or maybe the March 20s.
In the preceding example, suppose the stock makes a quick move to 21—a 10 percent increase. The professional will make 2 points on the purchase of a Jan 15 call or 11⁄2 points on the pur- chase of a Jan 171⁄2 call—returns of 50 percent or 75 percent, respectively. The novice might have a larger percentage return, but he might actually make less money because it is unlikely that he would buy such a large quantity of out-of-the-money options that he would make more money than the trader who bought, for example, 20 in-the-money calls.
In order to quantify these concepts, you can judge how aggres- sive your option purchase is merely by looking at the delta of the call being bought. The lower the delta, the more aggressive the option purchase. If you think of the delta as being the probability of the option being in-the-money at expiration—which is an alternative, but still correct, way of viewing delta—you can see how speculative an out-of-the-money option purchase is.
Even if you do correctly predict the direction of the stock and your option purchase is profitable, you must be prepared to take follow-up action to lock in your profits where applicable. One of the easiest ways to lock in some profits while still retaining potential, is to sell out part of your position after gains have been made. This works for any type of investment—stock, options, futures, bonds, and so on. The biggest problem with doing that is that if really large gains occur, you have reduced the quantity of shares or contracts that you own and you therefore don’t participate as much as you could have on the upside.
However, options actually sometimes provide a fairly easy means of having your cake and eating it, too—you can nail down some nice profits, but still preserve your “presence” in the stock. All that is required is to so sell the options you already own (and that are prof- itable) and buy the same number of options at the next strike. This is best accomplished when the stock has already reached the next strike, so that you are selling an in-the-money option and buying an at-the-money one.
Example: Suppose that you bought 10 XYZ June 20 calls for 2 each when the stock was 21. This costs $2,000 before commissions. XYZ subse- quently rallies to 25, and your calls are now worth 5 (at least). Upon investi- gation, you see that the July 25s are selling for 11⁄2. You could therefore do the following:
Sell 10 June 20 calls at 5: $5,000 credit Buy 10 July 25 calls at 11⁄2: $1,500 debit
You therefore take a nice healthy $3,500 credit out of the position, less commissions—which more than covers your $2,000 initial cost—and you still have 10 long calls in case the stock explodes on the upside. The worst that can now happen is that the July 25s expire worthless, if the stock takes a dive. However, you have locked in a profit already, so that needn’t overly concern you.