Call Option Buying Strategy Part 1

But looking beyond this is where calls become the most interesting. Calls can also be put to work in ways beyond mere speculation.

Strategy 1: Calls for Leverage

Leverage is using a small amount of capital to control a larger investment. While the term usually is applied to borrowing money to invest, it also perfectly describes call buying. For a few hundred dollars placed at risk, you control 100 shares of stock. By "control," we mean that the option buyer has the right (but not the obligation) to buy the 100 shares at any time prior to expiration, with the price frozen by contract. Leverage enables you to establish the potential for profit with a limited amount of at-risk capital. This is why so many call buyers willingly assume the risks, even knowing that the odds of making money on the call itself are against them.

Example: Spotting the Advantage: You are familiar with a pharmaceutical company's management, profit history, and product line. The company has recently announced that it has received approval for the release of a new drug. The release date is three months away. However, the market has not yet responded to the news. You expect that the stock's market price will rise substantially once the market realizes the significance of the new drug. But you are not sure; the lack of response by the market has raised some doubt in your mind. By buying a call with six months until expiration, you expose yourself to a limited risk; but the opportunity for gain is also worth that risk, in your opinion. In this case, you have not risked the price of 100 shares, only the relatively small cost of the option.

Example.: Expanded Potential: Given the same circumstances as in the previous example, you also realize that price growth might not occur for one to two years. It may require market response and acceptance, so a short-term option will not provide the leverage you seek. A LEAPS call does provide you the long-term leverage in this situation. Buying a LEAPS call will require more investment, because you have to buy the additional time; but if you believe the stock has growth potential within the window of time, it would make sense to invest.

Profits can take place rapidly in an option's value. If the price of the stock were to take off, you would have a choice: You could sell the call at a profit, or exercise it and pick up 100 shares at a fixed price below market value. That is a wise use of leverage, given the circumstances described. Things can change quickly. This can be demonstrated by comparing the risks between purchase of 100 shares of stock, versus the purchase of a call.

For example, the stock was selling at $62 per share. You could invest $6,200 and buy 100 shares, or you could purchase a call at 5 and invest only $500. The premium consists of 2 points of intrinsic value and 3 points of time value.

If you buy 100 shares, you are required to pay for the purchase within three business days. If you buy the call, you make payment the following day. The payment deadline for any transaction is called the settlement date.

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