Buying Calls in Anticipation of Gains

A few days ago we talked about buying puts to bet on a decline in the value of a stock. Today we're going to talk about buying calls when you're anticipating an increase in the value of a stock. Aside from the fact that buying a put is a bearish strategy and buying a call is a bullish strategy, the two strategies are nearly identical.

Learning to Speak Optionese: Buying Calls in Anticipation of Gains

When you think a stock is going down you should buy puts, and when you think a stock is going up you should buy calls. Creating a position is as easy as simply buying one or the other! The mechanics are the same, but calls profit from a stock's price increasing (as opposed to puts profiting from when a stock's price decreases). When the option expires, if the strike price is below the stock's current price then you make the difference. For the purpose of clarity, I am going to retell the story of the traders Bob and Phil, except this time, Bob and Phil are bulls!

Bob and Phil Go Long on PALM

After PALM's most recent quarterly earnings the stock hit a fresh 52 week high. However, as the hype died, the rally died with it. Soon the bears took control and PALM began a significant decline of over 30%.PALM hit bottom at around 10.50 a share and has stayed there since. It now seems that PALM may start moving back up again, and so call options have become more attractive.

Traders are unsure of exactly where PALM's stock price will go in the two weeks before expiration, but with a few well purchased calls they can easily profit from PALM's potential rally. One trader, Phil, believes PALM will rally all the way into the 14's before expiration. He thinks PALM will easily trade in the mid teens by the end of the week. However, his coworker Bob disagrees. "If PALM does rally," says Bob, "the 12's will hold the bulls back until after November expiration." Yet again, Bob and Phil disagree on what to expect out of a trade. Despite their disagreement, their opinion of PALM is bullish, and so their trades will be fundamentally similar. Let's look at what call's they should buy to best profit from their positions.

First, let's consider what Phil should do. Phil believes PALM will go to the high 13's or low 14's. Both the 11 and 12.50 call options are well priced in the case of PALM, but if PALM is going to 14, what will give Phil the maximum profit? In Phil's case, despite the fact that the November 12.50 calls only have time value, he should be a buyer of the 12.50's. If PALM does go to 14 before expiration, Phil will make 1.33 a contract, or an incredible 782.35% return! Despite how great that large percentage looks, if PALM stays in the 10's, 11's, or anywhere under 12.50 Phil will lose all the money he spent on the November 12.50 call's when the options expire! Surely Bob will make fun of him if that happens.

On the other hand, Bob will likely buy the November 11 calls. He is bullish on PALM. He even thinks PALM will eventually rally beyond 12. However, Bob likes the November 11 calls because the strike price is very close to the current stock price, and once they gain intrinsic value (which they should quite soon), his trade will be a surer thing then the November 12's. Plus, if PALM doesn't do much before November's option expiration, he can still manage to get some of his premium back.

As Bob and Phil have yet again shown us, when trading options there are many factors to consider. Most importantly, we have to decide how much risk to take on (the November 11's or the November 12.50's?) and what our price target for the underlying stock is (12 or 14?), once we have decided on these things we can structure a trade that will maximize profit. Calls are an indispensable tool to any trader who wants to have all the advantages of being long stock with less risk and more leverage. As with all options, your maximum loss is only the premium you paid for them. Whether you're a conservative trader like Bob or a risk-taking speculator like Phil there are call contracts that will fit well with your trading strategy.

Until next time,

Spencer Sundahl