CURRENT TRENDS

"BUY CALL" STRATEGIES

Wednesday, September 27, 2006, 5:52 AM ET

Strategy in brief: Buy a call option and benefit from the stock price upturn.
When to use this strategy: you are very bullish on the stock. The more bullish you are, the higher strike you should choose.
Comments:

• No other strategy gives you so much leveraged advantage with a limited downside risk.
• You can participate in the upward price movements by paying just the option price (a fractionof a stock price) - that's all your investment at risk.
• This strategy provides a great advantage over the outright stock purchase when you risk ten
times more capital.

Strategy in brief: Buy a call option and benefit from the stock price upturn. When to use this strategy: you are very bullish on the stock. The more bullish you are, the higher strike you should choose. Comments: ·         No other strategy gives you so much leveraged advantage with a limited downside risk. ·         You can participate in the upward price movements by paying just the option price (a fraction of a stock price) – that’s all your investment at risk. ·         This strategy provides a great advantage over the outright stock purchase when you risk ten times more capital. Let’s consider the following example (assume current price of IBM at $114 here and in all further examples).   Figure 1: Buy Call Strategy Example Profit: increases as the stock rises. At expiration, break-even point will be option strike plus option price paid. For each point above break-even, profit increases by an additional point. Loss: limited to the option price paid. Maximum loss is realized if the stock ends below the strike. For each point above the strike, the loss decreases by an additional point. Risk: limited. Reward: unlimited. Margin: not required. Time value decay: this position is a wasting asset. As time passes, the value of position erodes toward expiration. If volatility increases, decay slows; if volatility decreases, decay speeds up. Near-the-money option with a 115 strike has a maximum time value. Research Findings and Trading Tips: ·         The higher the strike, the less you pay for participating in the upward stock price movement. Many call option buyers intuitively prefer out-of-the-money options. This is a very common mistake. Absolute price really doesn’t matter! However, keep in mind that the stock might not swing up that high and your option can stay out-of-the-money on expiration. You must be very bullish to select this strike. ·         Options with lower strikes contain less time value (which you overpay for) and are less risky. At the same time, these options require a higher investment, thus making you risk more money. ·         Options with more distant expiration dates are less prone to time value decay. This is a good thing for option buyers. At the same time, they are less sensitive to the underlying stock price changes (by having lower deltas), thus being not so good for short-term speculations. ·         Some option traders bet on a difference between the actual and theoretical, “fair” prices. Assuming that a call option is “underpriced”, they expect its price to rise soon. Needless to say, this play can be very risky because the option price depends on too many factors. The most important of these factors is the underlying stock price: if it drops, the option price would fall substantially.   © "Worry-free Option Trading System"  &  Stock Markets Institute, 2002