When an investor buys an option he is said to be "long" the option. The same is true when you buy stock, you are said to be long the stock.

The most common form of option investing is buying calls on a stock that is expected to go up in value.

If you expected XYZ stock to rise from $45 to $55 over the next six months you could buy a call option. Depending on the timeframe you like there are many different ways to buy calls on any stock.

One investor with a short timeframe could buy front month calls At the Money (ATM). Another investor with a longer time horizon could buy an Out of the Money (OTM) LEAP call with two years until expiration. There are literally dozens of possibilities when investing with long calls.

Using the table below notice all the different call options available on XYZ Stock between June and December. This is not all of the strikes but just a sample for discussion. Just being an available strike price does not make it a worthwhile investment.

The options in green are ITM, blue are ATM and yellow are OTM.

Notice the $50 strike price. This is a perfect example of time value. The June options (three weeks to go as of this snapshot) have almost zero chance of being In the Money (ITM) by the expiration date. Anyone buying these would be giving money to the option writers. They have very little risk. They would have a windfall profit if the stock jumped +$5 in the next three weeks and they were called away for $50. For any contract they sell today they receive $25.00 (.25 x 100) and a chance for a $5 per share gain if the stock exploded higher.

Now notice the premium for the December $50 strike price at $2.20 The expectation that the stock will trade over $50 by December is much greater and by selling options today for $2.20 per share they are locking in a $7.20 gain over today’s stock price if the stock does trade over $50. It is like selling the stock for $52.20 today but not receiving the money until December. They do receive the $2.20 ($220 per contract) today and that is theirs to keep regardless of what happens to the stock. If the stock continued to hover around the $45 level the result would be the options expiring worthless and their basis in the stock would drop by $2.20 per share.

Notice the ATM $35 strike price for December. At $4.20 it is much higher than the OTM $50 strike price. Both options are completely extrinsic (time value only). There is no stock value in either. As a seller/writer of call options the writer of the $50 option has much more to gain since his total profit per share is $7.20. (XYZ $45.00 to $50 = 5.00 +2.20 premium) The chances of him getting his stock called away from him are much less than the writer of the $45 strike price. The writer of the lower strike will almost certainly be called even if the stock only rises by fifty cents. He has no stock appreciation from this point and all his profit is in the premium received.

Why would someone write the $45 call option instead of the $50? We do not know what basis the writer in the stock has today or their expectations for future stock movement. This stock has traded as low as $15 in the last 9-months. This writer could have bought stock then and by receiving a $4.20 premium and a $45 strike price they are making a nice profit of nearly 200% on their trade. If the stock falls flat and closes under $45 by December then they have reduced their basis by –$4.20 and they can repeat the process again. Many mutual funds use this strategy to maximize their gains and reduce their basis.

As buyers of call options I would not recommend investing in those options. The buyer of the December $45 call must see the stock trade over $52.20 by expiration before being sure of making a profit. The $45 strike is even worse. The stock would have to close over $49.20 to make a profit and well over $50 to double your money.

There are instances where buying LEAP calls makes sense but normally only when the stock has a much wider range of movement and/or the LEAPS are much cheaper.

Winning call Strategies:

There are several strategies I recommend for investing in straight calls. I will describe each and try to list the pros and cons of each. Just like some people like a Chevrolet over a Ford there is never just one right way with options.

Let me emphasize that long call strategies should only be used with upward trending stocks and stocks that are bought on a dip. Never buy calls on a flat stocks or a stock that is moving down or buy calls in a down market.

In The Money Calls.

Personally I like ITM calls the best of the different call strategies. Check out the time premium on the green row of $40 strikes below. If I thought the stock was going to move up to $50 between now and July expiration I could buy a July 40 call for $5.50. There is $5 stock value already and only 50 cents of time value. My breakeven point between now and July is $45.50. Anything over $45.50 and I am profitable.

Note the difference between the September $40 call at $6.20 and the $45 call at $3.10. I am going to pay more for the $40 call but I am only paying $1.20 in time premium. On the $45 call I would have no intrinsic value and $3.10 of time value. If the stock failed to move off that $45 level the $45 call would expire worthless but the $40 call would only lose $1.20.

The reason I like ITM calls is the Delta. Delta is the amount of movement of the option price compared to the movement of the stock price. Buying a $40 option on a $45 stock produces a position with almost a 95% delta. That means that for every $1 that the stock moves upward the option price will move 95 cents. With this type of option I can capture almost 100% of any upward move.

The second reason is value. Should the stock fail to rise quickly or flat line for some period of time I have very little time premium to decay. My option value stays steady and I am not at risk of losing my entire investment.

There are two downsides to this type of trade. One is the cost of the investment. If you have a sizeable account then a $6 option is not a problem. I feel you get what you pay for and I am paying for safety and delta. If the stock only moves +$3 then the option premium increases almost $3.

The second risk is the double edge sword of delta. If I have almost a 100% delta as the stock goes up then I also have almost a 100% delta as the stock goes down. A -$3 drop in the stock price will relate to a -$2.50 drop in the option price. The delta does decrease as the stock drops but it is still a sharp drop. This is my favorite type of long call trade since time decay is minimal. I only have to make sure I pick a stock that is trending up.

OTM Call Option

Another type of long call option trade is a slightly out of the money play. Using the XYZ chart as an example you could buy the July $47 call for $1.00. The hope here is that the stock trends upward for the next two months and eventually passes $49, which would be my point to double my money. Breakeven is $48 ($47 strike + $1 premium) and anything over $49 would provide a 100% return or more.

The problem with this play is time and direction. I can’t be sure of any profit until the stock is over $48. Should the stock flat line or dip again my premium would evaporate. Since it is all time value and based on expectation, any change in that expectation and my premium could evaporate quickly. The $1.00 I paid could easily become less than 50 cents with only a small dip or 3-4 weeks of sideways movement. This essentially locks me into the play until expiration. You are stuck with the hope that eventually there will be an upturn and premium will appear again but while you are waiting it is dead money.

This is the most used play by option investors. Proponents of this type of play point to the minimum entry requirements of $1 and claim that it is all risk capital anyway. Since the highest premiums are ATM they hope for a rapid run up to the strike price and a rapid increase in the premium before the stock cycles again. If you pick the right stock then this will work like a charm but it is more of a trading tactic than an investment. OTM call players need to be constantly ready to grab a profit before the next downward cycle of the stock takes the time premium back again. Many traders focus on the front month or next month just OTM strikes like the July $47 above. With a $1.00-$1.70 option price there is no room for error and any downward dip can wipeout your entire premium. Conversely a sharp jump can multiply the premium quickly.

When trading OTM near term options you have to be right about direction and speed of movement. Be wrong about either and the option expires worthless. You can be right about direction only to see it hit your target two weeks after the option expired.

The best time to use the OTM strategy is after a big dip. Premiums are depressed and stocks tend to rebound quickly and even when they don’t reach their previous highs the time premium escalates as volatility increases.

You can also use this strategy on breakouts to new highs. When stocks hit resistance at their old high and pause for a few days you can speculate on a strike above the high for normally what is a reasonable premium. If the stock breaks out it can cover ground quickly as shorts begin to cover. Stocks making new highs tend to keep making new highs.

Deep out of the Money Calls

I am not a fan of deep out of the money calls. In this sample case it would be something in the $55-$60 range. The options are cheap because they are nothing more than a lottery play. If the company announces a new drug that cures cancer or is acquired by somebody else and spikes 25% in one day you are a winner. Unless you have a psychic on staff I would avoid those types of plays. The vast majority of time they will expire worthless.

Try to stay within $2-$3 of the stock price on a stock under $50 and within $5 of the stock price on a stock over $50. If you are buying options on stocks well over $100-$150 the premiums are normally so expensive that it is a gamble anyway that the stock will move enough to make up the $5-$10 strike difference and the $10 premium. Unless you have inside information or the stock is a rocket I would not play in that category.

If you like the options education you have been receiving and you are on a free trial then now is the time to subscribe. Don't wait until you miss a newsletter to decide you want to take the plunge.

subscribe now

We have a lot of new traders reading the newsletter and I get a lot of questions. Over the next several weeks I am doing a multi part mini course on options. How do the strategies work? I will describe all the various strategies including calls, puts, spreads, covered calls, naked puts, straddles, strangles, definitions, etc. Stay tuned!

Jim Brown

Send Jim an email