Buying Stock Call Option Part 3

Example: The Lesser of Two Losses: You bought a call two months ago for a premium of 5. It expires later this month and is worth nearly nothing, since the stock's market value has fallen 12 points, well below striking price. You will lose your $500 investment or most of it, whereas a stockholder would have lost $ 1,200 in the same situation. You controlled the same number of shares for less exposure to risk, and for a smaller capital investment. Your loss is always limited to the amount of call premium paid. This comparison is not entirely valid, however. The stockholder receives dividends, if applicable, and has the luxury of being able to hold stock indefinitely. The stock's market value could eventually rebound. Options traders cannot afford to wait, because they face expiration in the near future.

You enjoy the benefits of lower capital exposure only as long as the option exists. The stockholder has more money at risk, but is not concerned about expiration. It would make no sense to buy calls only to limit risks, rather than taking the risks of buying shares of stock. A call buyer believes that the stock will increase in value by expiration date. Risks are limited in the event that the estimate of near-term price movement proves to be wrong, but are inapplicable for long-term risk evaluation.

Strategy 3: Planning Future Purchases

When you own a call, you fix the price of a future purchase of stock in the event you exercise that call prior to expiration. This use of calls goes far beyond pure speculation.

Example: All a Matter of Timing: The market had a large point drop recently, and one company you have been following experienced a drop in market value. It had been trading in the $50 to $60 range, and you would like to buy 100 shares at the current depressed price of $39 per share. You are convinced that market value will eventually rebound. However, you do not have $3,900 available to invest at the moment. You will be able to raise this money within one year, but you believe that by then, the stock's market value will have returned to its higher range level. Not knowing exactly what will happen, one alternative in this situation is to buy a LEAPS call. To fix the price, you can buy calls while the market is low with the intention of exercising each call once you have the capital available. The 40 LEAPS call expiring in 12 months currently is selling for 3, and you purchase one contract at that price. Six months later, the stock's market price has risen to $58 per share. The call is worth 18 just before expiration. The same strategy—looking ahead one year—would not have been possible with shorter-term listed calls.

In this case, you would have two choices. First, you could sell the call at 18 and realize a profit of $1,500. Second, you could exercise the call and buy 100 shares of stock at $40 per share. If you seek long-term growth and believe the stock is a good value, you can use options to freeze the current price, with the idea of buying 100 shares later.

The advantage to this strategy is that your market risk is limited. So if you are wrong and the stock continues to fall, you lose only the option premium. If you are right, you pick up 100 shares below market value upon exercise.

Some option speculators recognize that large drops in overall market value are often temporary, as a single-stock reaction to marketwide short-term trends. So a large price drop could represent a buying opportunity, especially in those stocks that fall more than the average marketwide drop. In this situation, investors are likely to be concerned with the risk of further price drops, so they hold off and miss the opportunity. As an options trader, you can afford to speculate on the probability of a price rebound and buy calls. When the market does bounce back, you can sell those calls at a profit.

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