Buying Calls Instead of Buying Stock

So here's another tip if you are looking for short term gains by trading stocks.  Let's say you want to buy 100 shares of Apple (AAPL) stock for a short term (1-6 months) gain.  Apple has been down a lot over the past nine months or so.  It hit its 52 week high back in September 2012 and hit its low of around $390 in April 2013.  It has started to climb back and is currently trading at $452 per share.  Apple is a great company and its potential to increase is stock price is pretty good.  To buy 100 shares it would cost you $45,200.  That's a lot of money just to buy 100 shares so one might considering buying a call option for a much lower price.  Call options have a few disadvantages vs. stocks.  #1 they expire, #2 you have to pay a premium over the intrinsic value which is called "time value".  But there are situations where buying a call is much smarter and better cost effective

Looking at the call options for Apple, we want to give ourselves enough time and we want to reduce the amount of time value we have to pay.  In this situation I would suggest buying a deep in the money call about four to six months before expiration.  Let's select the October 18 expiration and let's look at a call about $40 to $50 in the money.  The $410 call expiring on October 18, 2013 costs $52.60.  The time value is ($52.60-(452-410)) = $10.60.  We are paying a $10.60 premium over the intrinsic value.  What this means is if we hold this call option until expiration we would need Apple's stock to increase by at least $10.60 to break even ($462.60).  But our goal is to sell our call well before expiration so this time value isn't a big concern for us.

To control 100 shares of Apple (right to buy at 410) we will pay $52.60 * 100 = $5,260.  This is much more affordable than paying for 100 shares ($45,200).

The delta on our 410 call is .72 so for every $1 gain on the stock our call option will gain .72.  This delta will increase as the stock price increases so keep that in mind.

Let's say Apple increases in value to $460 in one month.  If we were to buy the 100 shares we would have made a profit of $800 for a percentage gain of 1.77%.  Not bad at all.  Our call option will increase about $570.  Our delta was .72 initially so if we took .72 *100 * 8 = $576.  Without going through all the math I would estimate this call option would increase by about $570.  We need to deduct a little time value since it took one month and we will need to increase our delta slightly since the stock went up (probably increase to .75).  Our percentage gain would be $570 / $5,260 = 10.84%.

As you can see, if we are correct and the stock price does in fact increase in value we can make a much greater percentage gain by buying a deep in the money call option instead of buying the stock.  Its a great tool to use for short term or medium term speculative plays.  These options won't tie up too much money and if you are right you are rewarded with very nice percentage gains.

My main option strategy is credit spreads and I'll cover that soon.

Jonny

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