Take a call

Buying a call option, a simple trading strategy, can offer vast gains if the market is expected to be bullish in a short period.

After discussing the basic terms and concepts in options in the previous issue, we move to trading strategies. One of the simplest strategies involves buying a call option. This, however, is advisable only when one expects a bull market in the near future as the buyer can profit from the increase in the price of the underlying security. He can lock in the price of the stock/index and profit if it rises over the lock-in price or strike price. On the expiry of the contract, the buyer can purchase the stock at a lower price, or strike price, and sell it at the market price. The difference between the market price and strike price will constitute the profit.

However, if the market moves against expectations, that is, if the market price falls below the strike price, the buyer can let the contract expire. If this happens, the maximum loss he incurs is the premium paid, along with brokerages and commissions. The break-even point (no profit, no loss) is achieved when the market price of the underlying security equals the sum of the strike price and premium (also brokerage, commissions). This strategy offers the opportunity for unlimited gains as, theoretically, the stock price can rise to any level beyond the strike price.

The holders of a long call consider the cost of purchase (option premium) as an insurance against the fall in the underlying stock’s price. Those who hold the stock call options have no stockholder or ownership rights, so they cannot claim the right to dividends, bonus or vote. To be eligible, the holders must take possession of the underlying stock.

The profit potential of this strategy depends on the rise of the underlying and the kind of option purchased (ITM or OTM). The buyers who buy deep OTM call options, that is, whose market price is substantially less than the strike price, are bullish on the underlying. The deeper the OTM option, the cheaper it is. This is because the value of the OTM option derives only from the time factor, that is, expectations that the underlying price will rise beyond the strike price over time.

OTM call options are the best money multipliers if the underlying price makes a sharp rise. However, these options are at the risk of expiring worthless if the price of the underlying stays flat. One can also go for the ITM call options, but these are more expensive than the OTM options as their value (premium) includes intrinsic value along with the time factor. So buying ITM call options results in large initial cash outlays. To understand the long call strategy, consider an example:

Mr. X is bullish on the ABC Ltd stock and decides to buy one ABC call option contract on 3 June 2009, which expires on 25 June. The ABC call option has a strike price of Rs 450 and is available at a price (option premium) of Rs 15. The market lot of the contract is 100 shares and the stock in the cash market is trading at Rs 445. The option is OTM as the strike price is more than the cash market price.

For simplicity, we shall assume zero brokerages and commissions. The cost of buying one call option contract of ABC Ltd is Rs 1,500 (100x15). Mr. X will exercise the option if ABC stock closes over Rs 450 on 25 June. If ABC closes below Rs 450, Mr. A can let the option expire and his loss will be limited to Rs 1,500, the premium paid. There will be no loss or gain if ABC closes at Rs 465 (strike price plus option premium), which is known as the break-even point.