THE OPTIONS COURSE- LONG CALL

THE OPTIONS COURSE


LONG CALL

In the long call strategy, you are purchasing the right, but not the obligation, to buy the underlying shares at a specific price until the expiration date. This strategy is used when you anticipate an increase in the price of the underlying stock. A long call strategy offers unlimited profit potential with limited downside risk. It is often used to get high leverage on an underlying security that you expect to increase in price.

When the underlying security price rises, you make money; when it falls, you lose money. This strategy provides unlimited profit potential with limited risk. It is often used to get high leverage on an underlying security that you expect to increase in price. Zero margin borrowing is allowed. That means that you don’t have to hold any margin in your account to place the trade. You pay a premium (cost of the call), and this expenditure is your maximum risk.


Perhaps the only drawback is that options have deadlines, after which you cannot recoup the premium it cost to buy them. Thus, you need to buy calls with enough time till expiration for the underlying to move into the profit zone—at least 90 days—or simply purchase LEAPS with a year or two until expiration. In addition, it’s best to buy calls with low implied volatility to lower the breakeven and minimize the debit to your account.

FIGURE  Long Call Risk Graph

Long Call Mechanics

In this example, let’s buy 1 March XYZ 50 Call @ 5.00, with XYZ trading at $50. This trade costs a total of $500 (5 × 100 = $500) plus commissions. The maximum risk is equal to the cost of the call premium or $500. The maximum reward is unlimited to the upside as underlying shares rise above the breakeven. The breakeven is calculated by adding the call premium to the strike price. In this example, the breakeven is 55 (50 + 5 = 55), which means the underlying shares have to rise above 55 for the trade to start making a profit. 

In Figure, note how the numbers that run from top to bottom indicate the profit and loss of this trade. The numbers that run left to right indicate the price of the underlying asset. The sloping line indicates the theoretical profit or loss of the call option at trade expiration according to the price of the underlying asset. Note how the loss is limited to the premium paid to purchase the call option.

The risk graph of the long call shows unlimited profit potential and a limited risk capped at $500. The breakeven is calculated by adding the call premium to the strike price. The long call breakeven is slightly higher than the breakeven on the stock, but this is the trade-off a trader takes for opting for a position with less risk and a higher return on investment.

Exiting the Position

A long call strategy offers two distinct exit scenarios. Each scenario primarily depends on the movement of the underlying shares, although volatility can have a major impact as well.

XYZ rises above the breakeven (55): Offset the position by selling a call option with the same strike price and expiration at an acceptable profit; or exercise the option to purchase shares of the underlying market at the lower strike. You can then hold these shares as part of your portfolio or sell them at a profit at the current higher market price.
XYZ falls below the breakeven (55): If a reversal does not seem likely, contact your broker to offset the long call by selling an identical call to mitigate your loss. The most you can lose is the initial premium paid for the option.

In this example, let’s say XYZ rises 10 points to 60. There are two ways to take advantage of it: exercise or offset it. By exercising the March 50 call, you will become the owner of 100 shares of XYZ at the lower price of $50 per share. You can then sell the shares for the current price of $60 a share and pocket the difference of $1,000. But since you paid $500 for the option, this process reaps only a $500 profit ($1,000 – $500 = $500) minus commissions. The more profitable technique is to sell the March 50 call for the new premium of 14.75, an increase of 9.75 points. By offsetting the March 50 call, you can make a profit of $975 ($1,475 – $500 = $975)—a 195 percent return!

Conversely, if you had bought 100 shares of XYZ at $50 per share, you would have made a profit of $1,000 (not including commissions) when the shares reached $60 per share—an increase of 10 points. The profit on the long stock position is slightly higher than the profit on the long call—a big $25. However, the return on investment is much higher for the long call position because the initial investment was significantly lower than the initial capital needed to buy the stock shares. While both trades offered profit-making opportunities, the long call position offered a significantly lower risk approach and the power to use the rest of the available trading capital in other trades. 

For an initial investment of $5,000, you could have purchased 10 call options and made a total profit of $9,750—now, that’s a healthy return. The ability of a call option to be in-the-money by expiration is primarily determined by the movement of the underlying stock. It is therefore essential to know how to analyze stock markets so that you can accurately forecast future price action in order to pick the call with the best chance of making a profit. Understanding market movement is not an easy task. Although it takes time to accumulate market experience, you can learn how various strategies work without risking hard-earned cash by exploring paper trading techniques.

Long Call Case Study

In order to illustrate how the long call works in the real world, let’s consider an example using a familiar name—Intel (INTC). Suppose you were studying some research notes on Intel and it seemed to you that the stock price had fallen too far given the outlook for the company’s semiconductor sales. The chart pattern also seemed to suggest that the stock was due to move higher. With shares trading near $15.75, you expect it to move above $20 by year-end. So, you decide to establish a bullish trade on the chipmaker.

Instead of buying shares, you decide to buy the INTC January 17.50 call. That is, you will buy the call option on Intel that has the strike price of 17.50 and has an expiration month of January. The current premium is $2.55 per contract and you buy 10 contracts. The total cost of the trade is therefore $2,550: (2.55 × 10) × 100 = 2,550. Since Intel is trading near $16 a share at the time, this call is out-of-the-money. Many call buyers prefer to use out-of-the-money calls because they provide the most leverage. It is a very aggressive way to trade the market.

To calculate the breakeven, we add the option’s strike price to the contract price, or 17.50 plus 2.55. The breakeven equals $20.05 a share. Often, traders will exit the long call strategy before expiration if the stock moves dramatically higher or falls too far below the breakeven. Recall that time decay is the greatest during the last 30 days of an option’s life. Therefore, it is best not to hold an option like the long call during that time. In addition, many traders will exit the position if it does not move in the anticipated direction. 

For example, if INTC drops below $15 a share, the trader might choose to close the trade. In that case, the $15 level would be considered a stop loss, or a predetermined price point where the trader exits a losing trade. In any case, rarely will the long call be exercised when it is purchased in anticipation of a move higher in the underlying security. Instead, the position is closed through an offsetting transaction. Specifically, you will sell 10 INTC January 17.50 calls to close.

We can see that if the stock falls the call will lose value. In contrast, profits begin to build as the stock moves higher. The maximum risk is equal to the premium, or $255 per contract. The upside potential is quite large. In fact, in this case, Intel not only rose above $20 a share that year, it topped $30. As a result, by the end of the year, the INTC January 17.50 call was worth $17.50 a contract—for an 11-month 600 percent gain!

FIGURE  Risk Graph of Long INTC Call 

Long Call versus Long Stock

As you can see, a long call strategy has many advantages compared with buying stock. For clarity’s sake, let’s review these advantages.

Cost. The premium of an option is significantly lower than the amount required to purchase a stock.
Limited risk. Since the maximum risk on a long call strategy is equal to the premium paid for the option, you know before entering the trade exactly how much money you could potentially lose.
Unlimited reward. Once you hit breakeven (call strike price + call option premium = breakeven), you have unlimited reward potential as in a stock purchase.
Increased leverage. Less initial investment also means that you can leverage your money a great deal more than the 2-for-1 leverage buying stock on margin offers.

The only drawback is that options have a limited time until they expire. But even this disadvantage can be seen as an advantage if you consider the opportunity cost of waiting months and sometimes years for a stock that has taken a bearish turn to reverse direction.

SHORT CALL

In a short call trade, you are selling call options on futures or stock contracts. This strategy is placed when you expect the price of the underlying instrument to fall. If you want to short a stock, your risk curve would fall from the upper left-hand corner to the lower right-hand corner. Notice how the horizontal line slants upward from right to left, providing insight as to its bearish nature. When the underlying instrument’s price falls, you make money; when it rises, you lose money. This strategy provides limited profit potential with unlimited risk.

It is often used to get high leverage on an underlying security that you expect to decrease in price. Selling a call enables traders to profit from a decrease in the underlying market. If the underlying stock stays below the strike price of the short call until the option’s expiration, the option expires worthless and the trader gets to keep the credit received. But if the price of the underlying stock rises above the short call strike price before expiration, the short option will be assigned to an option buyer.  A call buyer has the right to buy the underlying asset at the call strike price at any time before expiration by exercising the call. 

If the assigned call buyer exercises the option, the option seller is obligated to deliver 100 shares of the underlying stock to the option buyer at the short call strike price. This entails buying the underlying stock at the higher price and delivering it to the option buyer at the lower price. The difference between these two prices constitutes the seller’s loss and the buyer’s open position profit. This can be a huge loss in fast markets, which is why we never recommend selling short, or “naked,” options.

FIGURE  Short Call Risk Graph

Selling naked calls is not allowed by many brokerages. Some may require you to have at least $50,000 as a margin deposit. This speaks volumes about just how risky this strategy can be. However, since a short call is very useful in hedging and combination options strategies, it is important to understand its basic properties. In the case of selling options, be advised that you will initially receive money into your account in the form of a credit. This is the premium for which you sold the option. 

This strategy is used to generate income from the short sale of an option, since it provides immediate premium to the seller. In addition, it’s best to short calls when the implied volatility of the option is high; that way, you maximize the premium received. This is vital since the profit on a short call is limited to the premium received, and the position has an unlimited upside risk. As you can see by looking at the risk, this is a very risky strategy because it leaves the trader completely unprotected.

Short Call Mechanics

Let’s create an example that shows the trader going short 1 Jan XYZ 50 Call @ 5.00. The trader collected $500 (5 × 100 = 500) minus commissions for this trade. The maximum reward is limited to the credit the trader receives at the trade’s initiation. Conversely, the risk on this trade is unlimited as the price of the underlying asset rises above the breakeven. The breakeven of a short call equals the strike price of the call option plus the call premium. 

In this trade, the breakeven at expiration is 55: (50 + 5 = 55). As the market drops, the position increases until it hits the maximum credit (i.e., the amount of premium taken in for the call. Please note that a short call comes with unlimited risk to the upside. It is very important that you learn how to create covered positions (i.e., sell an option and buy an option) to limit your risk and protect against unlimited loss.

When the underlying stock reaches a price of 50, the position’s profit hits a maximum of $500 (the credit received). The call’s potential loss is unlimited and continues to increase as the price of the underlying asset rises above the $55 breakeven. If the market price of the underlying asset doesn’t rise, you get to keep the credit. However, this is the most that can be made on the trade.

Exiting the Position

A short call strategy offers three distinct exit scenarios. Each scenario primarily depends on the movement of the underlying shares.

• XYZ falls below the call strike price (50): This is the best exit strategy. The call expires worthless at expiration. This means you get to keep the premium, which is the maximum profit on a short call position.
• XYZ rises above the call strike price (50): The call will be assigned to a call holder. In this scenario, the call seller is obligated to deliver 100 shares of XYZ at $50 per share to the assigned option holder by purchasing 100 shares of XYZ at the current market price. The difference between the current market price and the delivery price of $50 a share constitutes the loss (minus the credit of $500 initially received for shorting the call).
• XYZ starts to rise above the breakeven (55): You may want to offset the position by purchasing a call option with the same strike price and expiration to exit the trade because assignment becomes increasingly likely once the time value of an option falls below 1/4 point.

Short Call Case Study

When looking for short call candidates, what we want to see is a stock that has run into resistance and that is expected to move lower before option expiration. Since we are selling the call, we also want to use time decay to our advantage by selling front month options. Lastly, we are looking for a stock that has options that are showing high implied volatility (IV) compared to the past. The higher the IV, the larger the premium we receive up front. Let’s look at a real-world example for a short call.

In late May 2003, we could have run a search for stocks that had options showing high implied volatility. One stock that would have shown up was Northrop Grumman (NOC). On May 26, NOC spiked higher, but ran into resistance near $90. By entering a short call, we have unlimited risk to the upside. This means that if the stock moves sharply higher, we have to come up with the money to cover the call. However, we get a credit immediately from the sale of the call, though margin will be needed. 

In our example, NOC was at $87.96 as of the close of trading on May 27. At that time, we could have sold the June 90 call for $1.10, or $110 per contract. In this case, our maximum risk is unlimited as the stock rises and our maximum profit is the initial credit received. Our breakeven point is found by adding the credit we received (1.10) to the strike price of 90: (1.10 + 90 = 91.10). Thus, the breakeven point as of expiration is at $91.10.

FIGURE  Risk Graph of NOC Short Call 

This occurs because the trade has unlimited risk as the stock rises. For most traders, this type of trade is too risky to undertake and it requires a lot of capital to be held in margin. Nonetheless, for the trader who has the funds and uses appropriate money management, a short call can be profitable. In our example, shares of NOC remained below $90 all the way through June expiration on June 20. In fact, the stock was making a move higher when expiration hit, but this trade still would have closed with a maximum profit of $110 per contract.

COVERED CALL

Covered call writing (selling) is the strategy that seems to be promoted most by the investment community. Many stockbrokers use this technique as their primary options strategy, perhaps because it is the one technique they are trained to share with their clients. It is also widely used by many so-called professional managers. Nevertheless, it can be a dangerous strategy for those who do not understand the risks involved. A few publications describe this technique as a “get rich quick” method for investing in the stock market, but it can become a “get poor quick” strategy if done incorrectly.

What is this technique all about? The purpose of the covered call is to increase cash income from a long stock or futures position. It provides some protection against decreases in the price of a long underlying position or increases in the price of a short underlying position. A covered call has limited profit potential and can result in substantial losses; but these potential losses are less than those for an unprotected long stock or futures position. A covered call write is composed of the purchase of a stock (or futures contract) and the sale of a call option against the purchased underlying asset. 

Remember, the buyer of a call option has the right to call the option seller (writer) to deliver the stock at the price at which the option was purchased. Therefore, if you write an option you are the seller, and you are responsible for delivering the stock at the strike price at which the option was sold to the purchaser if the option is exercised. At the inception of the transaction, you receive a premium, which pays you for the time value of the option as well as any intrinsic value the option may have at that time. You may be wondering what is wrong with the whole concept of covered call writing. 

Why are so many people incorrect when they use this strategy? Many traders simply do not know the risks they are assuming when they implement this overused technique. If you placed covered calls in stocks that only go up, you could make out very well. However, how many people pick stocks that only go up? A range-bound stock exhibits price action between two specified points: resistance and support. Resistance is the point at which prices stop rising and tend to start to drop. Support is the point at which prices stop dropping and tend to start to rise. 

When a stock rises, it hits a certain price where the sellers rush in, outnumbering the buyers, and thereby causing prices to start to fall off. The support level is the place where the price has become low enough for buyers to start to outnumber the sellers and the price begins to rise again. If this recurs over a specified period of time (e.g., six months), strong support and resistance levels have probably been established. Stocks that exhibit these tendencies can be excellent candidates for covered call writing. However, you must be aware that nontrending stocks also can begin trends, and many may begin trending to the downside.

Covered Call Mechanics

Let’s create a hypothetical example using a technology stock with the name XYZ Computer Corp. The ticker symbol for shares is XYZ and the company is one of the world’s leading computer sellers. The company has performed exceptionally well, with shares rising more than 400 percent in a one-year period! Let’s say XYZ Computer is trading at $49 per share after numerous stock bonuses, and we decide to place a covered call trade. Let’s buy 100 shares of XYZ at $49 each. This part of the trade costs $4,900 ($49 × 100 = $4,900). The amount of margin (the capital required) would be half this amount, or $2,450. 

In a covered call strategy, a trader offsets the purchase cost of shares with the sale of a call option. The covered call consists of selling one call for each 100 shares owned. The call can have any strike price and any expiration; however, this step can be difficult. You have to choose which option to sell.  You have a multitude of choices: near-term, long-term, in-the-money, out-of-the-money, at-the-money, and so on. Many covered call writers sell options one or two strikes out-of-the-money (OTM) because they want the shares to have a little room to run up before reaching the strike price at which the option was sold. 

Let’s say that on September 9, XYZ is trading at $49, and the October 50 and 55 call options (which have 40 days to expiration) have the following option premiums:

• October 50 Call @ 2.75.
• October 55 Call @ 1.75.

In this example, let’s go long 100 shares of XYZ at $49 and short 1 XYZ October 50 call at $2.75. This transaction has two sides, the debit (purchase of shares) and the credit (sale of option). The debit equals $4,900 ($49 × 100 = $4,900); however, the amount of margin (the capital required to place the trade) would be half this amount, or $2,450. In addition, you would receive a $275 credit (2.75 × $100 = $275) for the short option on 100 shares of stock.

If the stock rises from $49 to $50, the strike price of the option, you make an additional $100. You also get to keep the $275 credit you received. In total, your profit will be $375. If the stock goes to $55 you still get $375. If the shares go to $100 you still get only $375. In both these instances, you have to deliver the shares to the assigned purchaser of the option as it will be exercised at expiration since the option is in-the-money (i.e., the share price is greater than the strike price of the option).

Figure  Covered Call Risk Graph

That means that for an investment of $2,075: ($2,450 – $375 = $2,075), you can make $375 if the stock rises to at least $50 by expiration—a 17 percent return in only 40 days. Lastly, the breakeven of a covered call is calculated by subtracting the credit received on the short call from the price of the underlying security at trade initiation. In this trade, the breakeven is 46.25: (49 – 2.75 = 46.25).

In Figure, the risk graph for the covered call example, notice how the profit line slopes upward from left to right, conveying the trader’s desire for the market price of the stock to rise slightly. It also shows the trade’s limited protection. As XYZ declines beyond the breakeven (47.25), the value of the stock position plummets as it falls to zero. Thus, the inherent risk in this strategy rears its ugly head.

Overall, the covered call offers a slightly better approach than if you simply purchase the stock at $49 and watch it drop, because you have reduced your breakeven price by 2.75 points. XYZ must drop below this new breakeven price (46.25) to start losing money at expiration. But once it falls below the breakeven, losses can accumulate quickly. Now let’s say you sell the October 55 calls at 1.75; then your breakeven price is higher at $47.25 ($49 less the 1.75 received for selling the 55 call).  By selecting the higher strike call option to sell, you will receive less of a credit and will raise your breakeven price for the stock. 

However, then you have a greater potential return on the investment if and when the stock goes up. Obviously, you lose money when the stock goes below the breakeven price. Bottom line: each option has a certain trade-off for the option writer. You have to decide which one best fits the market you are trading. As mentioned previously, if the price of XYZ stock has been going up significantly over the past year, covered call writing would not have hurt you. You may not have received the 400 percent gain stock purchasers received, but perhaps you could have slept better at night, as you would have reduced your breakeven point. 

Unfortunately, traders may select stocks that have just begun a tailspin and lose 50 percent of their value overnight. In these cases, a covered call strategy will not help. These traders may get to keep the short option’s credit, but that will not go very far in light of losing 50 percent or more on the total price of the stock. There are numerous examples of companies losing 30 percent, 40 percent, 75 percent, or all their value in one day. Do not count on this strategy to save you from losing large sums of money if the stock makes a big drop. Writing covered calls can work. 

However, you must find stocks that meet one of two criteria: trending upward or maintaining a trading range. As exhibited with XYZ, covered calls work well with stocks on the rise.  Unfortunately, even stocks with upward trends have moments in which they make sharp corrections.  These periods are difficult for covered call writers as they watch their accounts shrink, because the covered call does not offer comprehensive protection to the downside. However, in many cases good stocks will rebound. 

If you do choose to write covered calls, do so only in high-grade stocks that have been in a consistent uptrend and have exhibited strong growth in earnings per share. To protect yourself from severe down moves, you can combine covered calls with buying puts for protection. If you purchase long-term puts (over six months), you can continue to write calls month after month, but you will have the added protection of the right to sell the underlying stock at a specific price.

Exiting the Position

Since a covered call protects only a stock within a specific range, it is vital to monitor the daily price movement of the underlying stock. Let’s investigate optimal exit strategies for the first covered call example, the sale of the 50 call.

• XYZ rises above the short strike (50): The short call is assigned. Use the 100 shares from the original long stock position to satisfy your obligation to deliver 100 shares of XYZ to the option holder at $50 a share. This scenario allows you to take in the maximum profit of $375.
• XYZ falls below the short strike (50), but stays above the initial stock price (49): The short call expires worthless and you get to keep the premium ($275) received. No losses have occurred on the long stock position and you can place another covered call to offset the risk on the long stock position if you wish.
• XYZ falls below the initial stock price (49), but stays above the breakeven (46.25): The long stock position starts to lose money, but this loss is offset by the credit received from the short call. If XYZ stays above 46.25, the position will break even or make a small profit.
• XYZ falls below the breakeven (46.25): Let the short option expire worthless and use the credit received to partially hedge the loss on the long stock position.

Covered calls are one of the most popular option strategies used in today’s markets. If you want to gain additional income on a long stock position, you can sell a slightly OTM call every month. The risk lies in the strategy’s limited ability to protect the underlying stock from major moves down and the potential loss of future profits on the stock above the strike price. Covered calls can also be combined with a number of bearish options strategies to create additional downside protection.

Covered Call Case Study

Covered calls are often used as an income strategy on stocks that we are holding long-term. They also can be used as a short-term profit maker by purchasing the stock and selling the call at the same time. The idea is to sell a call against stock that is already owned. If we do not want to give up the stock, we must be willing to buy the option back if it moves in-the-money. 

However, if we feel the stock will not rise above our strike price, we would benefit by selling the call. On December 1, 2003, shares of Rambus (RMBS) were falling back after an attempt to break through resistance at $30. The stock rose to a high of $32.25, but ultimately ended flat on the session right at $30 a share. Viewing the chart, we might have decided that $30 would hold and that entering a covered call strategy might work well.

By entering a short call, we have unlimited risk to the upside. However, by owning the stock, we mitigate this risk because we could use the stock to cover the short call. Let’s assume we didn’t already own Rambus, so we need to purchase 500 shares at $30 and sell 5 December 30 calls at $2.05 each. Our maximum profit for this trade is $1,025 [(2.05 × 5 ) × 100] and this occurs if the stock is at or above 30 on December 19. The maximum risk is still large because the amount of the credit for selling the calls does little for a major drop in the stock. 

Our breakeven point is at 27.95, which is figured by taking the credit received and subtracting it from the price of the underlying at trade initiation (30 – 2.05). Though we have limited our upside risk by using stock to cover the short call, we still have significant risk to the downside if the stock were to fall sharply. However, if the stock remains near $30, we get to keep the entire credit, even though there wasn’t a loss in the shares of stock. Since the passage of time erodes the value of the option, it’s best to use short-term options.

In our example, shares of RMBS did try several times to break higher, but each time resistance held and the stock ultimately closed at $26.37 on expiration December 19. At expiration, the stock position was down $3.63 a share, or $1,815: (3.63 × 500). However, the loss was offset by the $1,025 received from the credit from the short calls. So, the trade results in a $790 loss. A trader could continue to sell calls against the stock each month if it is felt the stock will remain near the strike price.

FIGURE  Risk Graph of Covered Call on RMBS 

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