When you start learning about options, the very first strategy you discover normally involves the purchase of a call aimed at taking advantage of a rise in the price of a stock. Let's examine how buying calls can improve your yields and offer a worthwhile alternative to buying shares on margin.
Mr. Y expects that ABC, which is currently trading at $20, will be going up shortly. He buys 1,000 shares in his margin account and puts up $6,000 (the minimum margin required on this stock is 30%). The other $14,000 required to complete this $20,000 purchase are borrowed on margin.
Ms. X also believes ABC will be going up. Instead of buying on margin, she decides to buy ten September 20 calls on ABC for $2 a share. She is therefore spending $2,000 on this trade (one contract = 100 shares).
Scenario 1: The stock goes up
The stock rises to $30 by September 19 (the third Friday of the month and the maturity date of the options). Mr. Y realizes a gain of $10,000 on an investment of $6,000 for a return of 166.67%.
Ms. X holds options that enable her to purchase 1,000 shares of ABC at $20 a share and then sell them for $30. She therefore realizes a gain of $10 a share, which works out to $8,000 on a $2,000 bet for a return of 400%.
Scenario 2: The stock drops
The stock drops to $10 by September 19. The value of Mr. Y's loan goes from $14,000 to $7,000, and he now has to find $7,000 in additional funds on top of having lost $3,000 on his original bet. This means he has lost a total of $10,000 on a bet of $6,000 for a negative yield of 166.67%.
Ms. X's options reach maturity with no value, and so she simply loses the $2,000 she initially bet for a loss of 100%.
The advantages of buying calls
Obviously, these scenarios represent extreme cases. Few stocks experience such wide moves in a short period. Our aim was simply to explain that buying on margin carries very high risks because potential losses are amplified. In buying options, your potential loss is limited.
Which option should you buy?
Are you ready now to buy an option? You have to choose the call's expiry month and strike price.
The first rule covering the selection of an expiry month is to avoid buying an option with a very short maturity. If you buy too short an option, you may miss the stock's move. If you buy too long an option, the call's price will not follow the stock's price as closely.
The selection of a strike price depends on your personality. If you are an experienced trader and are at ease on the markets, you may want to choose in the money calls. An option is said to be in the money when its strike price is lower than that of the underlying stock.
If you are looking more at betting on market fluctuations, you should buy an out of the money call. An option is said to be out of the money when its strike price is higher than that of the underlying stock. These cost less, meaning they provide more leverage. But the underlying stock has to fluctuate widely for you to obtain a substantial yield. You thus have a potential yield that is high – though highly improbable.