Thursday, September 01, 2005

Another way to look at a Call Option

Buying a call option gives you the right to purchase 100 shares of stock (it's normally 100, but it can be different depending on the contract) at a pre-determined price (the strike price). The option also has a specific time, so it might expire in two months. There are options that go out years (LEAPS). I've been interested in options for awhile, which is partly the reason why I'm switching brokerage accounts. I've read a few fairly detailed books on options, but I still need to study more. I especially need to put in more time if I want to try some advanced option strategies.

As for now, I was reading the options section for the CFA test and it's really basic. It basically covers the general definitions and the payoff diagrams. One part that I found really interesting was the way they described call options. I've always read that call options are generally a bad bet because people tend to buy options that are too far out of the money. They buy these because they are cheaper, but they still need the price to travel up a great distance. This is also one of the big reasons why people say options are risky, but it is because they take their chances and buy these deep out of the money calls (this is just one reason, but an important one).

The book explains the riskiness of calls by showing the percentage the underlying (the shares) need to move before the call goes into the money. In the book example they calculate a break-even price taking into account the premium the buyer needs to pay for the call option. Then you calculate how much the underlying will need to increase in order to cover the cost of the option. In the example the underlying would have to increase by 4.1% in one month in order to break even! Now, depending on the price, this might amount to a few dollars or less, but it's still 4.1%. The book says it perfectly: The underlying must go up by about 4.1 percent in one month to cover the cost of the call. This increase equates to an annual rate of almost 50 percent and is an unreasonable expectation by almost any standard.

I've never thought about calls in this way, and I found it pretty interesting.

1 comment:

wannabe_ceo said...

It's amazing the amount of ways people find to make money outisde of regular buy and sell. Call, options, shorting, etc.
Think I'll just stick with mutual funds for now and leave that other stuff to you all.