Call Buying Introduction
Call Option Positions
Call Option Characteristics
Which Option Do I Purchase?
What if the Stock Price Drops?
Closing Your Call Option Position
Call Buying Example
Example - Using the CallsAndPuts.com "Buy Calls" Data

Option Strategy:            
Call Buying (Buy In-The-Money Calls)

Investor Sentiment:       
Extremely bullish, somewhat speculative

Profit Potential:           
Realize revenue if stock (and underlying call option) increases in price during a set period of time.

Leverage:
The call buyer can control more shares for profit versus buying the stock outright.       

Risks:                             
If stock price stays the same or decreases during the option period, the option buyer can lose entire investment.  The risk to the call buyer is limited to the amount paid for the option premium.

Drawbacks:                    
This strategy relies on timing and judgement in upward price movement.  This investment strategy requires the price to move in an upward direction in a set time period.  There are many variables that can adversely affect the stock price in a set period of time (volatility, delayed product announcements, earnings news, rumors, etc) which are out of the control of the call buyer.  You may pick the correct price movement, but it may not happen at the correct time (during the option period).  The investor must select both variables of time and upward price movement correctly or he/she loses entire option investment. 

Call Buying Introduction

Call option buying is an extremely bullish, somewhat speculative strategy.  The investor is anticipating that the stock will move in an upward direction at some point between the time the option is purchased and the expiration date.  As soon as the call buyer executes an order to purchase options, time is ticking and working against the purchaser.  The call option buyer is anticipating that a profit can be realized when the stock price moves up and the position can then be closed or exercised.  The question can then be asked, "why not just buy the stock , hold it until the stock moves upward to a pre-determined price, and then sell the stock"? 

The advantage of buying call options versus buying the stock is the ability to leverage your investment.  An investor can gain a much larger return on his or her investment by controlling a larger number of shares with a purchase of call options rather than paying the full stock price.  Because more option shares can be purchased than stock shares for a set amount of money, a slight movement in the stock (and underlying call option) will generate greater returns on your investment.

There are two criteria that affect the pricing of call options.  The first variable is the time period between the purchase date and expiration date.  Generally, if the call option expiration date is further into the future, the more value the option will have and the price for the option will be higher.   The reason for this is the investor has a longer period of time available for the stock (and underlying call option) to move in an upward direction.  As time moves closer to the expiration date, the option has less time value because the stock price (and underlying call option) must move in an upward direction in a shorter time slice.   Option prices do not decrease in a linear fashion; the time premium erodes faster as the option nears the expiration date. 

The second variable that affects the call option price is the movement of the underlying stock.  If the stock price is moving in an upward direction, the call option premium may also be moving in an profitable direction.  This depends on the combination of time value and intrinsic or option value.  Because the call option is a derivative of the stock, the premium price is much smaller than the stock price.  Therefore, the upward movement of the option premium is a greater percentage return than the increased profit potential of buying the stock. 

For example, if you purchased a stock for $20 per share and the $20 May call is priced a $2 per contract, a movement of the stock to $24 per share would be a realized gain of $4 or 20%. But, the underlying May $20 option price may have increased from $2 to $2.75 or a 37.5% return on your investment.  Of course, this is just one example and option pricing can vary depending on stock volatility, delta formulas, quarterly earnings, rumors, timing, etc.  This will become more clear as we view examples and use the CallsAndPuts.com "Buy Calls" data.

Call Option Positions

There are a number of terms that describe the option strike price in relation to the stock price.  We will outline three terms, but keep in mind that CallsAndPuts.com lists call buying data that is slightly "In-The-Money", or a lower call option strike price than the current stock price.  This data presents a set list of Dow, Tech Stocks, and Internet Stock selections and the the nearest in-the-money call option available for that listed stock at market close each day. 

In-The-Money:        
This term refers to an option strike price that is lower than the current stock price.  For example, if a call buyer purchased the May $10 strike price against a stock that is currently priced at $12.50, this would be considered an in-the-money call position. The call option strike price is lower than the stock price.
At-The-Money:       
This describes an option strike price and a stock price that are the same.  For example, if a call buyer purchased the May $10 strike price against a stock that is currently priced at $10, this would be considered an at-the-money call position.
Out-Of-The-Money:
This call option position is riskier than the previously mentioned, but some investors find them tempting because they are the lowest priced options compared to at-the-money or in-the-money call options.  Because the call option strike price is slightly higher than the stock price, the stock price has to increase a greater amount (past the call option strike price) before profits can be realized.  In other words, the stock price has to increase a larger percentage in the same limited time period.  For example, if the stock is priced at $9.25 and we buy the May $10 call option, we are buying a call that is slightly out-of-the-money.   

Call Option Characteristics

There are a few call option characteristics that should be noted:

Options are available in specific months and at specific strike prices for optionable stocks (not all NYSE, AMEX and NASDAQ stocks have underlying options). Strike prices typically are available in $2.50 increments. Here is an example of available strike prices - $5.00, $7.50, $10.00, $12.50, $15.00, $17.50, $20.00, $22.50, $25.00, $30.00 and $5 increments for stocks priced above $25.

Option Expiration Day - Expiration day is at the market close of the third Friday of each month.  All option contracts for that particular option period are settled on the following day, Saturday.  On this date, your option position will be closed (you can close the position anytime from the purchase date to the expiration date) or your call option will expire worthless (the call option strike price is above the stock price).

Volatility - Call premiums are based on the potential upward or downward fluctuations in the stock price.  If there is a higher possibility for the price to move up or down, the call options are generally priced higher.   Because the call buyer tries to take advantage of these larger swings in a particular stock by timing the market, there is more demand for those premiums which increases the price of the call option.  As a general rule -- the higher the volatility of the stock, the higher the option premium because there is a greater possibility that the call option will move in a profitable direction.

Which Option Do I Purchase? 

There are multiple options for every optionable stock.   Not every stock on the NYSE, AMEX and NASDAQ have options available.  There are thousands of optionable stocks which translates to tens of thousands of options.  The difficulty for the investor is deciding which option to purchase and at what time.   Even if the investor knows which stock they want to invest in, they still have to decide which underlying option they should purchase on that stock.  This requires them to make a determination if an in-the-money, at-the-money, or out-of-the-money option will be the most profitable for a set period of time.  The two variables the call option buyer must determine: 1) which strike price to purchase on a selected call option, 2) How far in the future should the call option be purchased (option expiration date).

Typically, a call option buyer will generate profits if the stock (and underlying options) rises in price.  But, if an investor purchases the incorrect call option for a particular stock at an inappropriate time, the investor can go from a significant profit to being in a losing position that may be difficult to recover from.  Selecting the correct call option at the correct time is critical in taking advantage of buying call options.  Again, there is bigger risk and reward than purchasing stocks and holding them.  The investor has to evaluate their risk versus reward criteria and then be disciplined to execute his/her investment strategy.

In no way should a cheaper option price be the determinate in which call option to purchase.  The following factors must be considered when buying call options:

1. What is my time frame before I need to close my investment position and have access to my funds?
2. What is the percentage return criteria I am trying to meet?
3. What is my risk versus reward criteria?
4. Have I considered the worst case scenario and how I can recover from this in any given call buying situation.  What is my recovery strategy?

The time remaining before the call option expiration date is a key determinate in the decision criteria. If the stock is close to at-the-money and is nearing the expiration date, then the call option premium will closely track the change in the stock price. The CallsAndPuts.com "Buy Calls" data includes the first in-the-money (lower) call option for various high profile Dow, Tech, and Internet stocks.  Again, remember that even though the in-the-money call option is the most conservative call option purchase (compared to at-the-money or out-of-the-money positions), buying calls as its own strategy is very risky.  Time is working against the call option buyer as soon as the order is executed.   

What if the Stock Price Drops?

It is mandatory that the call option buyer consider his/her investment exit strategy.  The call option investor needs to decide before executing a call option what the exit strategy will be if the option drops in price.  At what point will the call option position be closed to minimize losses?  It is human nature to HOPE that the stock will rebound and the option price will recover.  But, due to time constraints associated with call options, the assumption should be it will take a longer period of time for the stock (and underlying call option) to rebound. 

Because time is such a major part of the valuation of an option premium, a dip in the stock price adversely affects the option premium to a much larger degree.  In this stock drop scenario, the option investor must make a decision to either: 1) Stay in the call option position and HOPE that it will rebound, or 2) Cut your losses by closing the call option position and take the remaining funds and place them in another investment.  The investor can control this situation by pre-determining at what point the loss isn't worth the risk.   

Closing Your Call Option Position

It typically isn't to the advantage of the call buyer to exercise the option due to the necessary capital and added commissions needed to purchase the underlying stock.  If a call buyer experiences a quick upward movement of the stock price, then the long call position should be closed to lock in profits.  View the other CallsAndPuts.com strategy pages to see how a combination of call buying and other option plays can maximize profit opportunities. 

Call Buying Example

Let's go through a call option example:

Stock Company Name/Ticker Symbol:       Cisco Corporation (CSCO)
Stock Price:                                                 $53.50
In-The-Money Option Premium:                      June $50 @ $6.50
Out-Of-The-Money Option Premium:               June $55 @ $3.50
Call Option Purchase Date:                            Purchased the $50 @ $6.50 on 5/15/00 ( I have 5 weeks for the stock price                                                                     to move in a positive direction)
Call Option Expiration Date:                          June (The market close of the third Friday of the month)

In this scenario, it was necessary to analyze whether to buy an in-the-money or out-of-the-money call option.  In either case, I am assuming that the stock price is going to make a significant upward move prior to the third Friday of June.  As the call buyer, I am well aware that time is working against me and I need the stock price to move up in a very short window of time.  You may ask, "what makes the call buyer assume that the price is moving in a positive direction"?  There are many variables and fundamentals that can be analyzed to draw this conclusion.  Possibly economic indicators (Bollinger Bands & RSI), earnings announcements, buyout or acquisition rumors, etc., are causing the price to fluctuate (volatility) which in turn increases the value of the option premiums. 

So, why did I select the in-the-money versus the out-of-the-money call?  Again, this is based on the call buyer's feelings of how much the stock will move in a given time period (thus, call option buying is a risky, somewhat speculative strategy).  Possibly, the tech stock sector has had a recent surge or rumors concerning a merger generated excitement in Cisco's future and drove the stock price up...there are a million different variables that can affect the judgement of the call buyer.  By selecting the in-the-money call option, I am anticipating that the stock price will have upward movement in a positive direction prior to the third week in June.  The conservative approach is to buy the in-the-money (lower) call option at $50, but that reduced risk is going to cost me $3.00 more per option ($6.50 - $3.50).  Call buying as a sole option strategy requires a strong stomach and some very reliable information to consistently be successful.  

Example - Using the CallsAndPuts.com "Buy Calls" Data

Now that we've explained the Call Buying strategy, let's use the CallsAndPuts.com "Buy Calls" data to select a call option play as an additional example: Buy Calls Example

CoveredCalls.com

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