Buying Call Options
Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.
Bullish Option | Speculative
Buying Call Options
Learn how to set up and profit from diagonal calendar spreads
blurb
The two most important reasons for setting up a covered call:
- Reduce cost basis of buying a stock
- Hedge an existing stock portfolio if you already own 100 shares of a stock.
- Covered calls are profitable even if the stock down’t move
A covered call reduces the cost basis of buying a stock by accepting a premium for selling a put above the stock price.
If you were to sell the 105 put for a premium of 5 dollars. The collected premium effectively lowers the cost basis of buying 100 shares of the stock at 100 dollars to buying the 100 dollars of shares at 95 dollars. The break even price is now 95 dollars.
A bullish long call diagonal spread is set up by
- Buy a distant month ITM call at a lower strike price
- Sell a proximate month OTM call at a higher strike price
- total debit paid should be no more than 75% of the strike width
- The intrinsic value of the long strike should approximate the short strike.
You will want to set this trade up in a low volatility environment but with a bullish direction.
A Long Call Diagonal Spread is constructed by purchasing a call far out in time, and selling a near term call on a further OTM strike to reduce cost basis. This trade is set up as a debit.
This option is typically closed when the short option expires. However, it is also common close the short option only to sell another short option for more premium either at the same strike price.
The setup of a diagonal spread is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast.
To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount.
The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes.
We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.
The best stock movement scenario = ( believe it or not ) is for the stock to move in your favor and blow by above your short strike.
The short strike would lose all of its value, but this is offset by the profit of the ITM in the money long options. You would collect the maximum profit of the ( strike width + the premium received ) or 10+5 = 15.
You would only manage a covered call if the stock price completely goes against you and is below the break even price.
Recall that a covered is profitable if either the stock price stays the same, moves between the strikes, or even it it moves above the short strike ( this is actually the best scenario )
If the stock moves in your favor and moves above the short strike, you will achieve maximum profit. The maximum profit is calculated by the width of the strikes minus the debit you paid.
In this example, the width is 10 and the debit it 5. So if the price goes above the short strike, you will collect a 5 dollar ( 10-5=5 ) profit.
If the stock moves against you and moves below the long strike, you will achieve maximum loss unless you adjust or manage your trade. Maximum loss is simply the price of your debit premium. In this case it is 5 dollars.
You will want to manage this trade by rolling the short strike down toward the long strike, while also narrowing the width of the spread.
Rolling the short strike should gain you a credit ( lets say .30 cents ) while also narrowing the width of the spread. This adjustment will lower the cost basis even if you continue to expect to lose money on the trade.
If the original debit was 5 dollars and you were able to get another 30 cents. Then even if you still lose in the trade, your loss has decreased from 5 dollars to 4.7 dollars.
If the stock price now manages to rally ( before expiration ) and rally back above the short strike, you will now be profitable albeit a lesser profit than originally designed. Remember that you managed this trade by bringing down the short strike and narrowing the strike width to 5 points wide. Your profit is based now on a strike width of 5 minus the debit which is now 4.7.
If the stock price does not move at all, the short strike will expire worthless and you would keep the premium.
The long call is simply the change in the value of the stock, which in this case has not changed.
So the value of the option is the profit of the premium that was sold. 5 dollars.
Note that you can manage this trade by moving the short strike ( for a profit ) toward the stock price if you can get a credit and you remain bullish on the trade.
Buying a naked call has negative theta. The option loses value as the option approaches expiration. The loss in value increases faster as time expires.
Selling a call has positive theta. The option benefits from time as it approaches expiration. The option price will decrease allowing us to buy the option back at lower and lower prices as the option approaches expiration.
A strangle is an option strategy that is set up buy simultaneously BUYING an ATM ( at the money ) call AND an SELLING an ATM put.
A conventional calendar spread is set up buy BUYING the same ATM call but SELLING the ATM call in a near month for credit.
The exact maximum profit potential cannot be calculated due to the differing expiration cycles used. However, the profit potential can be estimated with the following formula:
( Strike width – net debit paid )
Note however, that the cost basis can be refreshed by closing out the short strike and selling it again for a credit.
The break-even cannot be calculated due to the differing expiration cycles used in the trade. However, it can be approximated with the following formula:
( Long call strike price + net debit paid )
We generally look for 25-50% of max profit when closing diagonal spreads. Profit occurs when the long option moves further ITM and gains value, and/or if implied volatility increases.
A naked or long call option can be managed by converting it the naked call to a vertical call debit spread.
You would create the spread by selling a call above the long strike price and receiving a premium. By receiving a credit, you will be lowering the cost basis and maximum loss. You will be lowering your maximum risk.
The downside is that you will also be capping your maximum profit if the stock moves back in your direction.
If you are still undecided about whether the stock will ultimately be a loss, you can sell just a fraction of your contracts pending a more pressing decision point. The technical and sentiment should be reassessed, to make sure your original plan is intact. If not, then sometimes the best adjustment is simply to bail out.
Virginia Patients
Trade Management and Adjustments
Key Points
Not every stock you buy will go up or will every bullish or bearish options strategy go the direction you expect.
What should you do when things don’t go as planned?
Find out how to adjust your original long options strategy to potentially recover some or all of your losses, or even turn a losing trade into a winner.
If you are bullish on a stock, you might buy it. Or, you might decide to buy a long call option—giving you the right (but not the obligation) to buy the stock if it reaches the specified price during a specified amount of time—in order to limit your losses in case you’re wrong.
These two strategies are not perfect substitutes for the following reasons:
- Long stock involves ownership whereas an option position does not.
- Small declines in a stock position may eventually be recovered, whereas similar declines could cause an option to become completely worthless.
- Stock positions exist indefinitely in most cases while options always expire.
- Long stock owners have voting rights and can receive dividends if paid whereas option owners do not.
Long call options can also give you leverage that can result in a larger profit (from a percentage standpoint) than purchasing the stock outright. But you generally have to be right about the stock’s direction, the magnitude of the move, and often the time frame.
If you’re wrong about any of these items, the option can lose value and eventually expire worthless, resulting in a total loss. That’s the bad news.
The good news is, just because you bought a long call and the stock price has not increased, it doesn’t mean all hope is lost. It may still be possible to “manage” the position for a slightly modified expectation.
How can you manage your position?
Let’s review some examples. Assume it’s May 31, 2014 and you are bullish on XYZ with its $87.50 current price. Rather than buying 1,000 shares of XYZ, you have decided to make the following trade:
Buy 10 XYZ July 90 calls @ $3.50 (to open)
Net cost = $3,500 (3.50 x 10 x 100)
Days until expiration = 51
Breakeven = $93.50 (strike price + options premium)
Maximum loss = $3,500 (cost of the trade)
Maximum loss occurs at $90 or below, at expiration
Maximum gain = Unlimited
Commissions, taxes and transaction costs are not included in this discussion. Please be aware these costs can affect the final outcome significantly, and should always be considered.
Your original position
Source: Schwab Center for Financial Research.
Now, two weeks later, XYZ has dropped to $85.00 and your calls have fallen to $1.88. As a result, you currently have an unrealized loss of -$1,620. What do you do?
First, reassess your opinion of XYZ and ask yourself the following questions:
- Is my original price target still valid?
- How bullish or bearish am I on this stock? Am I still as bullish as I was? Slightly less bullish? A lot less bullish? Have I turned bearish?
- Can I lower my breakeven price?
- Should I lower my profit expectations?
- Am I willing to spend additional money to adjust this trade?
- Would it be better to just close my position and cut my losses?
There are many possible ways to manage your original position, but your answers to these questions may provide guidance.
A little less bullish than before
If you are still bullish (though a little less so), you might consider converting the original long call position into a bullish call spread by selling some higher strike calls.
Buy 10 XYZ July 90 calls @ $3.50 (to open) ◄original position
Sell 10 XYZ July 95 calls @ .75 (to open)
Net credit = $750 (.75 x 10 x 100)
Days until expiration = 37
Breakeven = $92.75 (original breakeven – new credit) or ($93.50 – $.75)
Maximum loss = $2,750 (net cost of both trades) or (-$3,500 + $750)
Maximum loss occurs at $90 or below at expiration (both options expire worthless)
Maximum gain = $2,250 (difference in strikes – net cost of both trades) or ($5,000 – $2,750)
Maximum gain occurs at $95 or above at expiration (stock is bought at $90 and sold at $95)
Net new position
Source: Schwab Center for Financial Research.
The effect of turning your long call position into this bull call spread is by forgoing any additional profit potential above $95, the maximum potential loss is reduced by $750 (to $2,750), the breakeven price is lowered by .75 points (to $92.75), and your unrealized loss is reduced by $750 (to $870).
A lot less bullish than before
If you are still bullish (though a lot less bullish than before), you might consider closing the original long call position, and creating a bullish call spread by reversing the original position and purchasing some calls with lower strike prices.
Buy 10 XYZ July 90 calls @ $3.50 (to open) ◄original position
Sell 10 XYZ July 90 calls @ $1.90 (to close)
Sell 10 XYZ July 90 calls @ $1.90 (to open)
Buy 10 XYZ July 85 calls @ $3.80 (to open)
Net debit/credit = $0 (($1.90 + $1.90 – $3.80) x 10 x 100)
Days until expiration = 37
Breakeven = $88.50 (long strike price + net cost of all trades) or ($85 + $3.50)
Maximum loss = $3,500 (net cost of all trades) or (-$3,500 + $1,900 + $1,900 – $3,800)
Maximum loss occurs at $85 or below at expiration (all options expire worthless)
Maximum gain = $1,500 (difference in strikes – net cost of all trades) or ($5,000 – $3,500)
Maximum gain occurs at $90 or above at expiration (stock is bought at $85 and sold at $90)
Net new position
Source: Schwab Center for Financial Research.
The effect of this new (lower strike) bull call spread is that while there is no additional upfront cost, you must be willing to forgo any additional profit potential above $90; the maximum potential loss remains the same ($3,500). However, the breakeven price is lowered by five points (to $88.50) and XYZ has to be below $85 (down from $90) at expiration in order to sustain the maximum loss. Finally, the unrealized loss remains at -$1,620 and the maximum gain is only $1,500 (rather than unlimited).
You are bearish
If you’ve completely changed your perspective on XYZ and are now bearish, you might consider converting the original long call position into a bearish call spread by selling some lower strike calls.
Buy 10 XYZ July 90 calls @ $3.50 (to open) ◄original position
Sell 10 XYZ July 85 calls @ $4.25 (to open)
Net credit = $4,250 (4.25 x 10 x 100)
Days until expiration = 37
Breakeven = $85.75 (short strike + net credit from both trades) or ($85 + $.75)
Maximum loss = $4,250 (difference in strikes – net credit from both trades) or ($5,000 – $750)
Maximum loss occurs at $90 or above at expiration (stock is bought at 90 and sold at 85)
Maximum gain = $750 (net credit from both trades) or (-$3,500 + $4,250)
Maximum gain occurs at $85 or below at expiration (all options expire worthless)
Net new position
Source: Schwab Center for Financial Research.
Now, the stock is already moving in the right direction, and at its current $85 price, is already slightly below your new breakeven of $85.75. Your original strategy was for XYZ to exceed $90, but if that occurs now, you will sustain your maximum loss. The new bear call spread strategy brings in a net credit, but your maximum potential loss actually increases by $750 (from $3,500 to $4,250). In addition, your risk has increased and your maximum profit is now limited to only $750 (versus unlimited previously), which occurs if XYZ is below $85 at expiration.
Stock stays flat
If you now feel that XYZ might just stay around its current level, you might consider creating a long call butterfly spread by entering a new ratio call spread.
Buy 10 XYZ July 90 calls @ $3.50 (to open) ◄original position
Sell 20 XYZ July 85 calls @ $4.25 (to open)
Buy 10 XYZ July 80 Calls @ $8.00 (to open)
Net credit = $500 (4.25 x 20 x 100) – (8.00 x 10 x 100)
Days until expiration = 37
Lower breakeven = $83 (middle strike – max gain) or ($85 – $2.00)
Upper breakeven = $87 (middle strike + max gain) or ($85 + $2.00)
Maximum loss = $3,000 (net cost of all trades)
Lower maximum loss occurs at $80 or below at expiration (all options expire worthless)
Upper maximum loss occurs at $90 or above at expiration (1,000 shares are bought at $80 and sold at $85 and 1,000 shares are bought at $90 and sold at $85)
Maximum gain = $2,000 (middle strike – lower strike – net debit from all trades) or ($5,000 – $3,000)
Maximum gain occurs at exactly $85 at expiration (1,000 shares are bought at $80 and sold at $85)
Net new position
Source: Schwab Center for Financial Research.
The effect of turning your original long call position into a long call butterfly spread is that if the stock remains relatively flat, you’ll end up in the profit zone. While hitting maximum profit on a long butterfly is virtually impossible (in this example, XYZ would have to be at exactly $85 at expiration) you have a four-point range ($83 – $87) over which it could be profitable. But if the stock moves above or below this range, you will sustain losses. If XYZ is above $90 or below $80 at expiration, you will sustain your maximum loss of $3,000.
Because additional trades needed to create this butterfly bring in a small net credit ($500), your maximum potential loss from your original long call position decreases by this amount. Additionally, your unrealized loss also goes down by $500 to only -$1,120. While your risk has gone down slightly, your maximum profit is now limited to only $2,000.
strategies introduction blurb
strategies introduction blurb
