Strategies in Buying Calls II
We know that investors buy call options to gain from an increase in the price of a stock or to lessen losses in case the stock price decreases. But, what other ways can call options be used to gain money? Other than profiting from an increase in the stock price or lessening your losses for a decrease in the stock price, investors also buy call options to give them more time in gathering the money needed to buy that stocks or to insure short stock sales. Note, however, that for purposes of simplicity, tax considerations, commissions as well as transaction costs have been omitted in my illustrations. Also, the call options here are assumed to be American style, which means that the call option can be exercised any time before the expiration period.
Assuming that you want to buy 100 shares of Stock A priced at the current fair market value of $55 per share but you do not have enough money to do so. You are however certain that in six months from now you would have enough money to buy 100 shares of Stock A. One of the ways you can use to buy shares of Stock A at $55 per share is to buy a $55 call option with an expiration date six months from now. Let us assume that the premium for a Stock A $55 call option is $4.25 (a total of $425 for 100 shares). If in six months time the stock prices of Stock A increase to $70 per share, you can exercise your call option and buy 100 shares of Stock A for only $5,500 instead of paying the full $7,000. You would have made a savings of $1,075 which is the difference between Stock A’s fair market value of $7,000 and $5,925 ($5,000 + $425). What if the price of Stock A declined to only $50 per share after 6 months? If the stock price declined then you can just buy your 100 shares of Stock A in the stock market and either let your call option expire or you can sell your call option to lessen your losses. In this case the maximum loss that you may incur is the premium that you paid for the call option.
You can also use call options to insure your short stock sales. Let us assume that you sold short 100 shares of Stock A with a current fair market value of $40 per share. Short means that you borrowed shares of Stock A from a broker and sold them in the stock market with the hopes that the stock price will decrease so that you can buy the stocks back at a lower rate. You can choose to buy a $40 call option for Stock A with an option premium of $3.50 so that you can insure that whatever the movement of the price you can still buy 100 shares of Stock A for only $40. Let us assume the stock prices of Stock A increase to $50, you can choose to exercise your call option and buy back the 100 shares of Stock A for only $4,000 instead of $5,000. Your total lost would only be the amount you paid for the option premium which is $350 instead of a possible $1,000.