Call Options

The Smart Profits Report: Issue #101
Monday, April 12, 2004

Call Options: Why Would Anyone Buy a Call?
By Karim Rahemtulla
Chairman, Mt. Vernon Research

About five years ago, when I first started trading options in earnest, I remember pausing to think: Why would anyone buy a call option - as in, ever?

After all, options are volatile. Their prices can change rapidly - both up and down. You have to be right about which direction prices are headed and how fast, or you can get nuked in the short term.

Plus, call options can expire worthless if you are wrong about the move of the underlying stock. Despite the big numbers you hear about, it still seems like a big risk. But sometimes, not taking risk with your “risk money” is the riskiest decision of all.

Let me explain…

Call Option Basics - Harnessing the Power of Leverage

In the options market, a call gives you the right to buy a certain stock at a certain price by a certain time. To clarify how that works, think of a call like a familiar real estate transaction, and you’ll see the strategic value of it…

Say you know of a piece of land that you’d like to buy because you are fairly certain it is going to become more valuable. That’s obvious to you because of all the interest in land in that area. Maybe you even know of some development headed that way. It’s too good to miss, but you don’t have all the money you need to take advantage of the opportunity… right now, at least. Or you don’t want to tie up that much capital. A fairly common situation.

So you decide to take an option on the land instead. You approach the owner and offer him a deposit to “hold” the land for you for six months at an agreed upon price. Now, let’s put some numbers to the example…

The price of the land is $100,000. You put up a deposit of $5,000 to have him hold the land for you at $100,000. At the end of six months, the land is worth $115,000. Since you still have the right to buy the land for $100,000 and can now sell it for $115,000, you have just made $15,000 on your $5,000 investment.

When you put up the $5,000, you entered into an OPTION contract with the seller. What’s more, it was a CALL because it gave you the right to decide to buy the land or not. Your deal satisfied the three criteria that make up an option contract: It had a price, expiration date and premium (the amount you paid for the right to buy the land.)

How To Control A Giant With A Midget-Sized Investment

Putting up $5,000 to control a $115,000 investment is an example of using leverage smartly. That kind of leveraging power was what prompted me to buy my first call option. I just did not have enough money to buy the underlying stock that had caught my eye.

In this case the stock was IBM. It was trading at $82 per share. I had been following IBM for some time, knew the situation well and, based on all of my analysis, I believed strongly that IBM was ready to move higher after its upcoming earnings release. But I did not have $82,000 on hand to spend on a thousand shares.

Since I didn’t, I decided to buy a call option rather than pass up this trade altogether.

Now, I knew that buying calls on stocks was a dangerous game. After all, if the shares did not move, I could lose all of my money.

Sometimes You Must Take Risks To Get Ahead

In my case I had to spend about $2 per option, or about $2,000 total, to control 1,000 shares of IBM. If I was right, I would make a bunch of money in a couple of weeks. If I was wrong, I would lose my $2,000. (I’ll admit I began with a particularly risky options trade, one with only two weeks’ time… If I’d bought an option with longer to run, my risk would have been lower.) Still, I felt that was better than having $82,000 at risk.

As fate would have it, IBM did report a blowout quarter, and the stock took off - to the tune of $15 per share. I pulled the trigger when the shares hit $90 and sold my option for an $8,000 net profit, or 300%, days later. I may have pulled out early, but you never can lose when you sell at a profit.

By the way, if I’d bought the shares, I would have profited, too. But I would only have made 9.7% and tied up $82,000 instead of $2,000. That’s why investors love options.

Start Looking For Movement Now

Can you take advantage of call options yourself? Sure. For now, you might start watching stocks you like and trying to spot those that are going to move up. See how well you do in your analysis with what you know now. We’ll tell you more about how the pros turn this knowledge into huge profits in future broadcasts.

Good Trading,

Karim

Today’s Smart Profits Crib Sheet

Frequently Asked Smart Question: “Isn’t buying a call option like gambling, or just trying to predict the future?” Karim: Not at all. The key to my purchase of IBM, as in the case above, was to have a system. My system with IBM at the time was to speculate on volatile companies right around earnings releases. While this system is very risky, it is still a system. I don’t use it anymore since there are better ways to profit from options. My point is this: If you are going to speculate using options, make sure you have a system in place that allows you to take smart, educated guesses about the direction of the stock. A tip from your second cousin’s ex-wife does not qualify as a system.
If you’re unsure about a “contract,” “call option,” “spread” or any other concept of options trading, just visit the Smart Profits Glossary to get information fast.

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