Tuesday, October 26, 2010

Options Trading: Buying Calls

Options trading is a real beast. I have been involved in trading options for about three years now and I have learned some interesting things. The number one rule I have decided that you must follow while options trading is "Be Rational". The number two rule that I have learned is that volatility is your friend. The third rule is don't listen to the bloggers!

Options trading is considered the poor man's investment vehicle. With very little capital any investor, or trader in this case, can participate in the financial market and try to speculate on the direction a stock will go. For example, Apple's stock is trading right now at $308.05 per share. So, I would have to come up with $30,805 in order to buy 100 shares. However, let's say you don't have that kind of cash under your couch cushion. You could purchase one call option that gives you the "right" to buy 100 shares of the stock if you want at some point in the future. There is a call option available that sells for $1,655 that would give an investor the right to purchase 100 shares of AAPL at any time before January 22, 2011 for $310 per share. Of course if the investor decides to exercise her options, she will have to come up with the $31,000 for the stock. The major benefit is that there is a chance that AAPL won't be worth $310 per share before January. Therein lies the big attraction, when buying a call option you are only putting $1655 at risk and you will never lose more than that, ever.

So, are options only good for managing risk? Not hardly let's look at the upside potential of owning call options. For the January $310 call you pay $1,655. Now assume that AAPL continues to grow in value and in January the stock is worth $350 per share on the expiration date. This would mean that you could exercise the option and purchase the stock at $310 per share and immediately sell all 100 shares for $350. This means your option has an intrinsic value of $40 per share. So, what is the ROI on the trade. Your investment was $1,655 and your profit would be the $40 times the 100 shares or $4,000. So, 4,000-1,655 / 1,655 = 141.69% in 90 days.

What if you just bought the stock? Let's say you buy 100 shares of the stock at $310 for a total of $31,000. The stock goes to $350 between now and January and you decide to sell all of your stake. That leaves you with a profit of $4,000, the same as before, right? Not so fast. Look at your initial investment. When buying the stock it cost you $31,000! So, 35,000 - 31,000 / 31,000 = 12.90%.

So, here is the catch! If AAPL fails to go any higher than $310 between now and January you lose all of your money. Granted it is only $1,655, instead of $31,000. So, you have limited the risk. You will never lose more than the premium you paid, and your profit potential is unlimited. This is why call options are so popular with small investors.

Statistics show that call option buyers lose money 85% of the time. But that 15% of the time that people win can be big.

I will explain more about options in the next posts! So, stay tuned!