Call Options

I have been posting about penny stock scams quite a bit. Probably the main reason why people fall for such scams is because the low price of these stocks is combined with high volatility, generating the illusion of quick and large gains from a small initial investment. Penny stocks are not the only security available that share these characteristic. Just like penny stocks options can be cheap to buy and can change their value quite drastically in a short time. That makes options another financial instrument that can be promoted to naive investors or traders.

This post is just an introduction to the topic of options, which I find in many respects fascinating.

First of all, it is important to understand what options really are. Options are for all intent and purpose insurance contracts. It is better to use an example to understand this concept.

Let's say that Susan wishes to buy 300 shares of General Electric. Yesterday GE closed at $35.47 a share. Susan is bullish and believe that GE will get much higher in price next month. Of course, she could just buy and hold until her target is reached and then sell for a profit. But, what if GE price doesn't go up? She would be stuck with a $300*35.47 = $10,641 investment that is not generating the desired gain or, worst, is losing money. Of course, she will be entitled to dividends (at $1 per share, a 2.8% yield) if she keeps the shares until the 25th of January. However, if GE goes down by more than $1 she will lose money on this investment.

Susan decides to buy 3 call options for GE that expire the 3rd Friday of February. Each option contract entitles her to buy from the contract writer 100 shares of GE at a specified price (the strike price) before or on the date of expiration of the contract. There are four such contracts available right now:

GE-BF, with a $30 strike price, that was priced $5.6 as of yesterday at the close.
GE-BZ, with a $32.5 strike price, that was priced $3.2.
GE-BG, with a $35 strike price, that was priced $1.05.
GE-BS, with a $37.5 strike price, that was priced $0.15.

In fact, the price of each contract must be multiplied by 100 because it corresponds to 100 shares of GE stock. That means that acquiring the right of buying 100 shares of GE before the 3th Friday of February at $30 costs $560.

Let's say that Susan purchases 3 such contracts. She spends 3*$560 = $1,680. If she were to take advantage of her acquired right immediately, she would spend 300*$30 = $9,000 to purchase the stock. Her total cost would therefore be $10,680, slightly higher than if she were to buy the stock at the closing price (I am disregarding commissions for the moment).
However, if she holds on the options and GE stock price goes, say, to $40 a share before the expiration of the options, she can exercises her right to buy at $30, sell at market and cash a gain of $3,000 - $1,680 = $1,320. On the other hand, if GE stock tanks below $30, she will do nothing and by the time the option expires her loss will be limited to $1,680.

Summarizing, if GE stock goes below $30, by buying the options instead of the stock, Susan is effectively insuring herself of stopping her loss at the option cost of $1,680. If she had purchased the stock directly at $35.47, her loss would be equal or larger than $1,641. On the other hand, in order to make any money she needs to see GE stock price go higher than $35.6 before the expiration. A call option with strike price lower than the market price of the underlying security is called "in the money". Such call options are the most expensive for a given expiration date.

The same consideration could be made for the other contracts available. Buying 3 calls at $35, with a price of $1.05 per share will stop the loss at 300*$1.05 = $315, but will generate a gain only if GE price goes higher than $36.05. This call option has strike price close to the market and it is called "at the money".

The cheapest call options are the ones with strike price above the market. They are "out of the money". Buying 3 calls at $37.5 limits the loss at just 300*$0.15 = $45, but will produce a gain only if GE goes above $37.65 before expiration.

Note how buying a call option in the money is pretty much equivalent to buy the shares of the underlying security and set a stop loss order at the strike price, the difference in the option case being that the capital outlay to purchase the shares occurs only if the trade is actually profitable.

At the other end of the range, buying a call option deep out of the money is more like buying a lottery ticket. The ticket is cheap but the chance of actually making money is slim.




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