The Money Calls where your sentiment about a stock would be termed extremely bullish and somewhat speculative. Using this strategy you realize a profit if the stock increases in price during a set period of time.
Remember, options allow the call buyer to control more shares for profit versus buying the stock outright. If the stock price stays the same or decreases during the option period, you can lose your entire investment. but your risk is limited to the amount paid for the option premium.
This strategy relies on timing and judgement and requires the price to move in an upward direction in a set time period. There are many variables that can adversely affect your stock price during this time such as volatility, delayed product announcements, earnings news, rumors, etc which are out of your control. You may pick the correct price movement, but it may not happen during the option period. You must select both variables of time and upward price movement correctly or you could lose your entire option investment.
As stated above, call option buying is an extremely bullish, somewhat speculative strategy. You are anticipating that a stock will move in an upward direction at some point between the time the option is purchased and the expiration date, which is always the 3rd Friday of the month you buy. As soon as you execute an order to purchase options, time is ticking and working against you. Remember, you are anticipating that a profit can be realized when the stock price moves up and the position can then be closed or exercised.
The advantage of buying call options versus buying the stock is the ability to leverage your investment. You can gain a much larger return on your 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 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 you have a longer period of time available for the stock to move up. As time moves closer to the expiration date, the option has less time value because the stock price must move in up in a shorter time. 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 provides a greater percentage return than the increased profit potential of buying the stock.
Let’s say you purchased a stock for $20 per share and the $20 April call is priced at $2 per contract, a movement of the stock to $24 per share would be a realized gain of $4 or 20%. But, the underlying April $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, quarterly earnings, rumors, timing, etc.
There are a number of terms that describe the option strike price in relation to the stock price.
First we have what is called In-The-Money and this term refers to an option strike price that is lower than the current stock price. For example, if you purchased the April $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.
Secondly, we have what is called At-The-Money which describes an option strike price and a stock price that are the same. For example, if you purchased the April $10 strike price against a stock that is currently priced at $10, this would be considered an at-the-money call position.
And finally, we have what is called Out-Of-The-Money which is a call option position that is riskier than the previously mentioned, but some 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 April $10 call option, we are buying a call that is slightly out-of-the-money.
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, $7.50, $10, $12.50, $15, $17.50, $20, $22.50, $25, $30, as you can see once you get above $25 they jump in $5 increments.
As stated above, 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), which we would never allow to do, nor should you. Remember, just as with a stock, if an option play goes against you, sell it and cut your losses, DO NOT sit there hoping it will reverse!
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 you try 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.
By now you should know there are multiple options for every optionable stock. The difficulty for you is deciding which option to purchase and at what time. Even if you know which stock you want to invest in, you still have to decide which underlying option you should purchase on that stock. This requires you 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 you must determine are which strike price to purchase on a selected call option and 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 rises in price. But, if you purchase the incorrect call option for a particular stock at an inappropriate time, you 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. You have to evaluate your risk versus reward criteria and then be disciplined to execute your investment strategy.
wallman is the member of Hot Penny Stocks
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Rob is the member of Penny Stocks