Buying Stock Call Options Part 2

You do not need to invest and place at risk $6,200 to gain that control. The stock buyer, in comparison, is entitled to receive dividends and does not have to work against the time deadline. Without considering trading costs associated with buying and selling calls, what might happen in the immediate future?

A point-for-point change in option premium value would be substantial. An in-the-money increase of 1 point yields 1.6 percent to the stockholder, but a full 20 percent to the option buyer. If there were to be no price change between purchase and expiration, three-fifths of the option premium would evaporate due to the disappearance of time value. The call buyer risks a loss in this situation even without a change in the stock's market value.

As a call buyer, you are under pressure of time for two reasons. First, the option will expire at a specified date in the future. Second, as expiration approaches, the rate of decline in time value increases, making it even more difficult for options traders to get to breakeven or profit status. At that point, increase in market value of the underlying stock must be adequate to offset time value and to yield a profit above striking price in excess of the premium price you paid.

It is possible to buy calls with little or no time value. To do so, you will have to select calls that are relatively close to expiration, so that only a short time remains for the stock's value to increase, and fairly close to striking price to reduce the premium cost. The short time period increases risk in one respect; the lack of time value reduces risk in another respect.

Example: Just a Little Time: In the second week of May, the May 50 call is selling for 2 and the underlying stock is worth 51.50 (11/2 points in the money). You buy one call. By the third Friday (the following week), you are hoping for an increase in the market value of the underlying stock. If the stock were to rise one point, the option would be minimally profitable. With only 1/2 point of time value, only a small amount of price movement is required to offset time value and produce in-the-money profits (before considering trading fees). Because time is short, your chances for realizing a profit are limited. But profits, if they do materialize, will be very close to a dollar-for-dollar movement with the stock, given the small amount of time value remaining. If the stock were to increase 3 points, you could double your money in a day or two. And of course, were the stock to drop 2 points or more, the option would become worthless. Considering trading costs, examples of small-point scenarios like this are most realistic for multiple-contract strategies. For example, if you were to buy 10 calls at $51.50, you would invest $510.50 plus trading costs; but on a per-contract basis, trading costs would be far lower than for a single-contract purchase.

Tip: Short-term call buyers hope for price movement, and they may need only a few points. The risk, of course, is that price movement could go in the wrong direction.

The greater the time until expiration, the greater the time value premium—and the greater the increase you will require in the market value of the underlying stock, just to maintain the call's value. For the buyer, the interaction between time and time value is the key.

Example: The Luxury of Time: You buy a call at 5 when the stock's market value is at or near the striking price of 30. Your advantage is that you have six months until expiration. For four months, the underlying stock's market value remains fairly close to the striking price, and the option's premium value—all or most time value—declines over the same period. Then the stock's market value increases to $33 per share. However, because the time value has disappeared, the call is worth only 3, the intrinsic value. You have lost $200.

Buying calls is one form of leverage—controlling 100 shares of stock for a relatively small investment of capital—and it offers the potential for substantial gain (or loss). But because time value is invariably a factor, the requirements are high. Even with the best timing and analysis of the option and the underlying stock, it is very difficult to earn profits consistently by buying calls.