Money Matters Wealth Tip #67 – Options 102: Trading Calls
Our focus for this article will be trading call options.
If you have been following along last week we briefly discussed options in general.
Options 101 can be found here.
While I will not get into every aspect of options. You can get the basics from last week’s where Puts and Calls are discussed.
Options limit your Risk
Many say that options are risky. I do not agree. The reality is that options limit your risk. If you buy an option you can only lose what you have paid which is only a friction of the cost of owning the shares.
As an example if you were to buy 100 shares of XYZ corp. at $10 per share your cost would be $1,000. If you bought a call option which is a right but not an obligation to buy shares it would be a fraction of the cost.
When you look at options you will see many different options available. Options will have different strike prices and any number of different expiration dates. The shorter the expiration the less premium you will pay. The option will move in lock step with the share price.
Pricing of options
Today is March 22, 2020. I may look at options expiring in 30 days or I could look longer. The closer the option is to expiration the lower the cost. If I was to go longer I would pay a premium.
Let’s go back to XYZ Stock currently trading at $10. I believe it will be increasing in price but am not sure when exactly. I am not comfortable with 30 days, I want to take 90 days.
When I look at options for XYZ I will look at June 20, 2020 option expiration with a strike price of $10. When I look at the pricing I see that the cost of an option is $1.50. What am I paying for, two things the right to purchase the shares at $10 and the time in which to purchase the shares. I have 90 days to exercise my right at $10 per share. Breaking the $1.50 down in time and the right. The cost of the time is $.75 about $.25 per month. While the right is $.75. To breakeven I will need the shares to increase by $1.50.
Exercise or not to Exercise
If I exercise my right to buy shares at $10 my cost would be $11.50. The cost to buy a share of $10 plus the cost of the option at $1.50. So my breakeven would be $11.50.
So why bother buying options? The stock will need to increase by 15% for me to breakeven. Here is the beauty of options.
If the price of the stock increase by $.25 in the first 30 days the options may increase $.20. A $.20 increase is a 13% increase in 30 days. Sell the option and put the profit in your pocket.
I will tell you that I have never exercised my right to buy a stock. I always sell the option.
Example (This is not a recommendation) for example purposes only
Zoom Video Communication (ZM) On March 18, 2020 it was trading in the range of $112 to $117 for the day. If I was to buy 100 shares at $115 it would have cost $11,500. A bit more than I want to spend. But when I look at an option at $115 I can buy it for less. I want a little bit of time but I do not want to pay a high premium. So I look at the pricing of an option expiring on May 15, 2020, 60 days.
The pricing of this option is $18.20. Each option is for 100 shares so the cost is $18.20 times 100 or $1,820. Now I have control of 100 shares for a fraction of the cost of the share price.
On Friday, March 21, 2020 Zoom closes at $130.55 per share a rather nice increase after two days. Owing the shares the profit would be $1,555 or 13.5%. A nice little return.
How did the options fair?
The options closed at $27.50. An increase of $9. Not as much as the actual shares but up $9. This give you some idea as to the premium build into the option price. But let’s see the results. The value of the option is now $2,750. Price paid was $1,850 a profit of $900.
Not as much as if I owned the stock. But remember you only invest $1,850 for a $900 profit that is a 48% return! A bit better than the 13.5% return if you owned the stock.
So you see the power of options.
Call option have power
The ability to increase your investment returns is higher with options than owning the stock. The risk is limited to the cost of the option. Returns can be unlimited. Remember to sell your options to take your profits. Never own on option on expiration.
This is an example only to give you a real time example of the power of options. In no way am I recommending any security.
A word of caution only trade with money you can afford to lose. Do not use your rent of mortgage money to trade. Every trade does not end in a profit. There will be loses along the way.
I hope this was helpful in your education. Next week we will discuss put options.
Future articles will discuss risk management.
Let me know what you think in the comments below. If you would like to know something let me now in the comments as well.
If you enjoyed this Money Matters Wealth Tip the series can be found HERE.
Other articles of interest:
10 Easy Steps to Creating a Budget that will put you on the path to Financial Independence
How to get out of Debt: Three popular Plans
4 Payoff Credit Card Debt Strategies
So what are you waiting for? Need help getting started, Grab our FREE budget tools to help you along on this very important journey.
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