Buying Stock Call Options Part 4
Strategy 4: Insuring Profits A reason for buying calls is to protect a short position in the underlying stock. Calls can be used as a form of insurance. If you have sold short 100 shares of stock, you were hoping that the market value would fall so that you could close out the position by buying 100 shares at a lower market price
The risk, of course, is that the stock will rise in market value, creating a loss for you as a short seller.
Example: Checking Your Shorts: An investor sells short 100 shares of stock when market value is $58 per share. One month later, the stock's market value has fallen to $52 per share. The investor enters a closing purchase transaction—buys 100 shares—and realizes a profit of $600 before trading costs.
A short seller's risks are unlimited in the sense that a stock's market value, in theory at least, could rise to any level. If the market value does rise above the initial sale price, each point represents a point of loss for the short seller. To protect against the potential loss in that event, a short seller can buy calls for insurance.
Example: Reducing Your Risks: You sell short 100 shares when market value is $58 per share. At the same time, you buy one call with a striking price of 65, paying a premium of 1/2, or $50. The risk is no longer unlimited. If market value rises above $65 per share, the call protects you; each dollar lost in the stock will be offset by a dollar gained in the call. Risk, then, is limited to seven points (the difference between the short sale price of $58 and the call's striking price of 65).
In this example, a deep out of the money call was inexpensive, yet it provided valuable insurance for short selling. The protection lasts only until expiration of the call, so if you want to protect the position, the expired call will have to be replaced with another call. This reduces your potential loss through buying offsetting calls, but it also erodes a portion of your profits. As a short seller, like anyone buying insurance, you need to assess the cost of insurance versus the potential risk.
Example: The Need for More: A short seller pays a premium of 2 and buys a call that expires in five months. If the value of the stock decreases two points, the short seller might take the profit and close the position; however, with the added cost of the call, a two-point change represents a breakeven point (before calculating the trading costs). The short seller needs more decrease in market value to create a profit.
Calls serve an important function when used by short sellers to limit risks. They also take part of their potential profit for insurance, so short sellers hope that the strategy will be profitable enough to justify the added expense. Using LEAPS calls in this situation will cost more but provide the same insurance for a longer period of time. The selection of a call to insure a short position depends on the length of time you plan to remain in the short stock position.
Example: The Effect of Rumors: An investor sold short 100 shares of stock at $58 per share. At the same time, he bought a call with a striking price of 65 and paid a premium of 2. A few weeks later, the underlying stock's market price rose on rumors of a pending merger, to a price of $75 per share. The short seller is down $1,700 in the stock (shares were sold at $58 and currently are valued at $75). However, the call is worth $1,000 in intrinsic value plus whatever time value remains. To close the position, the investor can exercise the call and reduce the loss to $700—the sales price of the stock ($58), versus the striking price of the exercised call ($65 per share). In this case, an additional call with later expiration and higher striking price could be purchased to continue providing additional insurance. This overall strategy makes sense only if the investor continues to believe that the stock's value will eventually fall, and recognizes that the use of calls is a valuable strategy while waiting out the short sale move. If the investor now believes that the stock is not going to fall, then continuing with the short sale in stock would not make sense; the smart move would be to close out the position and take the loss, before a larger loss occurs. Otherwise, if the stock's value continues to rise after the call has been closed, the investor risks further losses.
Example: Checking Your Shorts: An investor sells short 100 shares of stock when market value is $58 per share. One month later, the stock's market value has fallen to $52 per share. The investor enters a closing purchase transaction—buys 100 shares—and realizes a profit of $600 before trading costs.
A short seller's risks are unlimited in the sense that a stock's market value, in theory at least, could rise to any level. If the market value does rise above the initial sale price, each point represents a point of loss for the short seller. To protect against the potential loss in that event, a short seller can buy calls for insurance.
Example: Reducing Your Risks: You sell short 100 shares when market value is $58 per share. At the same time, you buy one call with a striking price of 65, paying a premium of 1/2, or $50. The risk is no longer unlimited. If market value rises above $65 per share, the call protects you; each dollar lost in the stock will be offset by a dollar gained in the call. Risk, then, is limited to seven points (the difference between the short sale price of $58 and the call's striking price of 65).
In this example, a deep out of the money call was inexpensive, yet it provided valuable insurance for short selling. The protection lasts only until expiration of the call, so if you want to protect the position, the expired call will have to be replaced with another call. This reduces your potential loss through buying offsetting calls, but it also erodes a portion of your profits. As a short seller, like anyone buying insurance, you need to assess the cost of insurance versus the potential risk.
Example: The Need for More: A short seller pays a premium of 2 and buys a call that expires in five months. If the value of the stock decreases two points, the short seller might take the profit and close the position; however, with the added cost of the call, a two-point change represents a breakeven point (before calculating the trading costs). The short seller needs more decrease in market value to create a profit.
Calls serve an important function when used by short sellers to limit risks. They also take part of their potential profit for insurance, so short sellers hope that the strategy will be profitable enough to justify the added expense. Using LEAPS calls in this situation will cost more but provide the same insurance for a longer period of time. The selection of a call to insure a short position depends on the length of time you plan to remain in the short stock position.
Example: The Effect of Rumors: An investor sold short 100 shares of stock at $58 per share. At the same time, he bought a call with a striking price of 65 and paid a premium of 2. A few weeks later, the underlying stock's market price rose on rumors of a pending merger, to a price of $75 per share. The short seller is down $1,700 in the stock (shares were sold at $58 and currently are valued at $75). However, the call is worth $1,000 in intrinsic value plus whatever time value remains. To close the position, the investor can exercise the call and reduce the loss to $700—the sales price of the stock ($58), versus the striking price of the exercised call ($65 per share). In this case, an additional call with later expiration and higher striking price could be purchased to continue providing additional insurance. This overall strategy makes sense only if the investor continues to believe that the stock's value will eventually fall, and recognizes that the use of calls is a valuable strategy while waiting out the short sale move. If the investor now believes that the stock is not going to fall, then continuing with the short sale in stock would not make sense; the smart move would be to close out the position and take the loss, before a larger loss occurs. Otherwise, if the stock's value continues to rise after the call has been closed, the investor risks further losses.
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