Introduction:
Options can provide an alternative approach to the traditional buy and hold strategy. Buying call options can add value to one’s portfolio via leveraging a small amount of cash while defining risk with unlimited upside potential. Simply put, buying a call option is bullish in nature as the buyer is positioning the trade with the thesis that the underlying shares will increase in value.
When one buys a call option, she is buying the right to purchase shares at a specific price on a specific date in the future for a nominal price. In this scenario, the buyer thinks the shares are undervalued hence why she is willing buy the option now to secure the right to purchase shares in the future at a higher price. If the shares approach the specific price or rise above the specific price prior to the expiration date then the underlying option becomes more valuable. This more valuable option can now be sold higher than when she purchased the contact to realize gains. In terms of percent, call options can be very profitable and scaled as needed. Risk in buying call options is capped based on the amount of the option itself thus downside risk is defined and upside potential is great. Here, I’ll discuss buying call options along with my approach, strategy and real world outcomes.
Anatomy of Buying Calls:
I rarely buy call options however in opportunistic scenarios the risk-reward is very favorable given a decent time horizon. Nominal amounts of cash can be deployed in opportunistic scenarios to capitalize on sell-offs in high quality stocks. Buying calls can be implemented as a means to leverage cash on hand without committing to actually purchasing the underlying shares of the company with the end goal of capitalizing on share appreciation via the option contract. The option price is determined by two variables, time and intrinsic value.
The amount of time until expiration of the contract determines the time value, the longer the contract will translate into more time value in the contract (Figure 1). Generally speaking if the underlying stock falls in value (moving away from the strike price) then the option will decrease as a function of time value. Alternatively, if the underlying stock appreciates (moving towards the strike price) then the option will increase in value as a function of time value. As the stock moves away or towards the strike price, the underlying stock is less likely (decrease in option value) and more likely (increase in option value) to reach the strike price, respectively hence the change in option value.
