- What Is a Cheap Option?
- Selecting a Call
- Overall Evaluation
- Selecting a Put
This chapter is from the book
This chapter is from the book
This chapter is from the book
Selecting a Call
When you buy a call option on a stock, you are taking the view that the stock is going to rise in price. You buy a call option instead of buying the stock to give yourself more leverage for a greater profit. If the stock goes up by 15 percent, your option might easily increase in value by 100 per cent or even more.
After you have decided what stock you want to play for a gain, you need to select an appropriate call option to buy. This is not as simple as it might seem. You will have many possibilities from which to make a choice. There will be several expiration months to consider, including the current month and other months that possibly go out as far as two years into the future. You will also have various strike prices to consider, including ones below the stock price (in-the-money), near the stock price (at-the-money), and above the stock price (out-of-the-money).
Which option is best? To answer this question, you must decide what you believe will be the manner in which XYZ makes its upward move. Is this a stock that is going to jump up 15 percent in the next two weeks due to a much better than expected earnings announcement? Or, is this a stock that will slowly rise by 25 percent over the next year? As you review various choices of call options, think about how much the stock must rise and the time frame during which that rise must occur to produce a profit. Also, if the stock does not make the expected move up, check to see when you can exit the trade to minimize your loss.
General approach: When you consider buying a particular call option, first determine what portion of its total price is time value. Keep in mind that this time value will ultimately be lost as the option expiration date arrives. Then ask yourself, "Can the stock price rise high enough and fast enough to increase the value of this option by an amount that will offset the loss of its time value and provide an acceptable profit?" If you can answer yes to that question, you have a good reason to buy the option.
Let’s look at some examples to illustrate this general approach. Some of the prices used in these examples have been estimated by using an options pricing calculator.
You think that XYZ is going to rise in price in the near to intermediate future. In early April, XYZ is at $67.
-
Example 3. You consider buying the Apr 70 call, which is priced at $1.50 per share. This option seems cheap enough, but is it a good one to buy? To answer this question, let's see what XYZ needs to do for this option to provide a reasonable profit.
-
Example 4. You consider buying the May 65 call, which is priced at $4.20 per share. This option seems much more expensive than the Apr 70 call, but is that really true? Let's see what XYZ needs to do for this option to provide a reasonable profit.
-
Example 5. You consider buying the Oct 65 call, which is priced at $8.30 per share. This option costs almost twice as much as the May 65 call in Example 4, but keep in mind that you are buying a lot more time. Let's see what XYZ needs to do to for this option to provide a reasonable profit.
The Apr 70 call expires in a little more than two weeks. Because this option is out-of-the-money, all of its $1.50 price is time value.
If XYZ rockets up to $73 in one week, the option might become worth $3.70 ($3 intrinsic value and $.70 time value). This represents a nice $2.20 profit on a $1.50 investment, but it required a 9 percent gain in the stock price in one week.
If XYZ only manages to rise gradually over the next two weeks to reach $71.50 just at expiration, the option will be worth $1.50 (all intrinsic value and no time value at expiration). In this scenario, XYZ has gone up by 7 percent in three weeks, but you only break even on the option trade.
Suppose XYZ barely edges up to $68.50 with one week remaining. Then, this option might be worth only $1 (all time value), because it is still out-of-the-money and has only one week of life remaining. Now you have lost $.50 per share on the option even though the stock has moved up slightly, and there is almost no time left to recover.
Summary: This April option is cheap, but to make a nice profit, the stock needs to make a significant rise soon after the trade is initiated. This is not a likely scenario, which makes this trade quite risky.
The May 65 call expires in seven weeks. Because this option is in-the-money, it has an intrinsic value of $2 [67 – 65 = 2]. Therefore, its time value is $2.20 [4.2 – 2.0 = 2.2]. In comparison with Example 1, we are paying for an extra $.70 of time value [2.2 – 1.5 = .7], but we have considerably more time for this option to return a reasonable profit.
If XYZ is able to make the 9 percent gain to $73 in five to six weeks, this option might be worth $8.60 ($8 intrinsic value and $.60 time value). This represents a nice profit of $4.40 on a $4.20 investment. Although the percentage profit on this option trade is not quite as good as compared with Example 1, the May option has allowed more time for the stock to achieve its rise to $73.
Suppose that XYZ does nothing for six weeks and then finally manages to move up to $71.50 in the seventh week just as expiration is reached. In this scenario, the option will be worth $6.50 (all intrinsic value and no time value at expiration). Here you have made a profit of $2.30 per share [6.5 – 4.2 = 2.3]. Compare this with Example 1, in which XYZ reached $71.50 at expiration and produced no profit.
If XYZ is at $69.20 at the May options expiration, the May 65 call will be worth $4.20 [69.2 – 65 = 4.2] for break-even.
Summary: Although this May option may seem expensive, it has some important advantages. By having a later expiration date, it gives the stock more time to make the desired move. By having a strike price that is in-the-money, the break-even point at expiration is lower.
The Oct 65 call expires in 27 weeks. Because this option has the same strike price of $65 as that of Example 2, its intrinsic value is the same $2 [67 – 65 = 2]. But this option has a time value of $6.30 [8.3 – 2.0 = 6.3]. In comparison with Example 2, we are paying for an extra $4.10 worth of time value [6.3 – 2.2 = 4.1], but we have an extra 20 weeks beyond the May expiration for this option to perform.
If XYZ is able to make a 9 percent gain to $73 in 18 weeks (about mid-August), this option might be worth $11 ($8 intrinsic value and $3 time value). This represents a profit of $2.70 on an $8.30 investment. Although the percentage profit on this option trade is not as good as compared with Examples 1 or 2, the October option has allowed considerably more time than either the April or May options to achieve its rise to $73.
Suppose that XYZ is able to make a 20 percent gain to $80 as the option nears expiration in October. Then the option will be worth $15 (all intrinsic value and no time value at expiration), and you will have made a profit of $6.70 on an $8.30 investment for an 81 percent gain. In this scenario, we have allowed almost seven months to achieve the 20 percent rise in XYZ. Such a rise would be much less likely in the shorter time spans described in Examples 1 or 2.
If XYZ is only at $70 in mid-September, this trade should be close to a break-even situation. At that time, you will have been able to follow the progress of XYZ for about 22 weeks. If the stock does not seem to be performing as expected, you could exit the trade without a loss.
Summary: This October option is the most expensive because it goes out the furthest in time and its strike price is in-the-money. The big advantage of this option is that it allows lots of time for the expected move in the price of XYZ to happen.