Buying Calls

Who Should Consider Buying Equity Calls?

• An investor who is very bullish on a particular stock and wants to profit from a rise in its price.
  
   
• An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk.
  
   
• An investor who anticipates a rise in value of a particular stock but does not want to commit all of the capital needed to purchase shares.
   

Buying an equity call is one of the simplest and most popular strategies used by option investors. It allows an investor the opportunity to profit from an upward move in the price of the underlying stock, while having less capital at risk than with the outright purchase of an equivalent number of underlying shares, usually 100 shares per call contract.

Definition

Buying an equity call gives the owner the right, but not the obligation, to buy 100 shares of underlying stock at a specified price (the strike price) at any time before a specific time (the expiration date). This is a bullish strategy because the value of the call tends to increase as the price of the underlying stock rises, and this gain will increasingly reflect a rise in the value of the underlying stock when the market price moves above the option's strike price.

The profit potential for the long call is unlimited as the underlying stock continues to rise. The financial risk is limited to the total premium paid for the option, no matter how low the underlying stock declines in price. The break-even point is an underlying stock price equal to the call's strike price plus the premium paid for the contract. As with any long option, an increase in volatility has a positive financial effect on the long call strategy while decreasing volatility has a negative effect. Time decay has a negative effect.

 

Participate in Upward Stock Price Movement With Limited Downside Risk

Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.

Example

ZYX is trading at $44.25, so 100 shares of stock would cost a total of $4,425. However, an investor could instead purchase one six-month ZYX 45 call, which represents the right to purchase 100 underlying ZYX shares at $45 per share, for a quoted price of $3.25. The total cost for the call would be: $3.25 x 100 contract multiplier = $325, a fraction of the total stock purchase price. Instead of committing $4,425 on the purchase of 100 ZYX shares, spending only $325 for the purchase of one call would leave a balance of $4,100 that could then be invested in short-term, interest-bearing instruments.

By purchasing the call the investor is saying that by expiration he anticipates ZYX to have risen above the break-even point: $45 strike price (at which price ZYX can be purchased no matter how high it has risen) + $3.25 (the option premium paid), or a ZYX share price of $48.25. The investor's profit potential is unlimited as ZYX stock price continues to rise above $48.25. The risk for the call purchase is limited entirely to the total premium paid for the contract, or $325, no matter how low ZYX stock price declines.

Before expiration, if the call purchase becomes profitable the investor is free to sell the option in the marketplace to realize this gain. On the other hand, if the investor's bullish outlook proves incorrect and ZYX declines in price, the call might be sold to realize a loss less than the maximum.

Consider three possible scenarios at expiration:

• ZYX closes above the break-even point
• ZYX closes between the strike price and the break-even point
• ZYX closes below the strike price

ZYX is above break-even point of $48.25 at expiration

If ZYX closes above the break-even point of $48.25 at expiration, at $51 per share for instance, the option will be in-the-money and worth its intrinsic value (difference between the strike price and stock price):

 $51.00   ZYX stock price
-$45.00  call strike price
   $6.00   intrinsic value

If you sell the ZYX 45 call for its intrinsic value of $6 then you would see a profit:

$6.00  intrinsic value received at call's sale
$3.25  premium initially paid for call
$2.75  profit

This profit of $2.75 ($275 total) represents a return on an initial investment of $3.25 premium paid for the call ($325 total) of approximately 84.6% over the 6-month life of the call contract.

The call could also be exercised, and 100 shares of ZYX purchased at the contract's strike price of $45 per share plus the $3.25 call premium paid, or a net price of $48.25. The stock could either be sold in the marketplace or held in anticipation of continued profits on the upside.

Instead of purchasing the call, had the stock been purchased outright at $44.25 per share and increased in price to $51 at option expiration, it would then be worth a total of $5,100. The result is a 15.25% return over the initial stock investment of $4,425 versus an 84.6% return for the option investor.

ZYX is between $45 and $48.25 at expiration

With ZYX exactly at the strike price of $45 at expiration, the $45 call would be exactly at-the-money and have no value. With ZYX at the break-even point of $48.25 at expiration the call's intrinsic value would be $3.25, or its initial cost. With ZYX closing between $45 and $48.25 at expiration, the $45 call will be in-the-money and have an intrinsic value of less than its initial cost. In this case the option could be sold to recoup some of its original purchase price resulting in a partial loss for the position.

For example, ZYX closes at $47 at expiration. The call's intrinsic value at this point would be:

  $47.00  ZYX stock price
-$45.00   call strike price
   $2.00   intrinsic value

ZYX did rise in value, but not as much as anticipated. The option that cost $3.25 is now worth $2, so the investor can sell the call and recoup some of its initial purchase price. If the ZYX 45 call is sold for its intrinsic value of $2 then the loss for the position would be:

$3.25   premium initially paid for call
$2.00   premium received at call's sale
$1.25   partial loss

The call could also be exercised. 100 shares of ZYX would be purchased at the contract's strike price of $45 per share plus the $3.25 call premium paid, or a net price of $48.25 per share. The stock could either be sold in the marketplace or held in anticipation of continued profits on the upside.

Instead of purchasing the call, had the stock been purchased outright at $44.25 per share and increased in price to $47 at expiration, it would then be worth a total of $4,700. The result is a 6.2% return over the initial stock investment of $4,425 versus a partial loss of $125 from an initial investment of $325 for the option investor. However, the call buyer could have earned interest on $4,100 not committed to the initial stock purchase, which could offset some of the option loss.

ZYX is at or below $45 at expiration

Say ZYX stock did not move as anticipated, but instead declined and closes at $40 per share at expiration. The ZYX call would expire out-of-the-money and with no value, so the investor would lose the total premium of $325 initially paid for the option. This would be the limited, maximum loss no matter how far ZYX stock had declined, and would also be realized if at expiration ZYX closed at any point at or below the $45 strike price and the call expired out-of-the-money.

Assume the same scenario of ZYX closing at $40 on expiration and consider an initial purchase of 100 shares at $44.25 instead of the call. At $40 per share, the 100 shares would have declined in value to $4,000. The stock investor would be facing an unrealized loss of $425, and would have incurred a greater loss if ZYX stock had declined even further. The option investor's loss, however, is limited to the $325 premium paid for the contract. The stock investor now has two choices: sell the stock and realize this loss, or hold onto the stock and hope for an increase in price to recoup some or all of the loss.

By purchasing the call for significantly less cash than an outright purchase of 100 ZYX shares, the investor limited the investment capital at risk if ZYX stock did not increase in price as anticipated. Now he still has the cash balance of his original investment capital, plus interest if it had been invested in short-term interest bearing instruments, with which to make another investment decision.