Call buying is probably the most recommended option strategy. That does not make it the best, and in some respects it is one of the most risky. But there are great times to buy calls, and this is one of them.
The appeal of call buying is that it is a limited-risk strategy with the potential to produce substantial gains. The leverage is huge, which is why "instant millionaire" hawkers often promote it.
For example, in Apple you could buy an April 440 call with the stock trading right around $430, ensuring the right to buy 100 shares at $440. The premium of that call is $6.30 at the time of this writing, for a total cost of $630. (Remember that 1 option represents 100 shares.)
An outright purchase of those 100 shares, meanwhile, would cost $43,000. So if Apple were to rally up to last week's high around $470, you would make $4,000 on the stock for a 9 percent return.
But the calls--if held until expiration--would make $2,370 ($47,000-$44,000-$630) for a 376 percent return. (See our Education section)
The problem is that there is only a 36 percent probability that AAPL will be above $440 at expiration and only a 7 percent probability that it will be above $470.
Most call buyers bet too much money on low-probability bets, and this over-leverage is what eats up capital. That is one of the biggest risks of this option strategy.
That said, there are times when buying calls makes a lot of sense. The markets are near landmark highs but volumes are light, and some believe that we are poised for a correction. And volatility is low, which can be seen in a general way in the VIX.
The volatility matters because it is a key component of the option's price. The higher the expected volatility, the higher the option price, and vice versa. Often in options, that expected volatility is higher than the actual volatility turns out to be, and that is the reason many professional traders use option-selling strategies. This presents the other big risk in option buying, that you are paying more than you should, in volatility terms.
If you are bullish on the overall market but worried about a potential pullback, then selling stocks and replacing them with long calls makes a lot of sense. You could buy SPDR S&P 500 Fund (SPY) calls to get that upside exposure, for instance.
The SPY Weekly 157 calls, with 10 days left to trade, cost $0.52 and have an implied volatility of less than 9 percent. That compares to the current 10-day historical volatility of 9.3 percent and a 30-day historical volatility of 11.3 percent.
The key is to only replace your current exposure, not to leverage up because of the lower cost of the calls. To be clear, I would not add long calls to a long-equity portfolio here; I would replace the stock with the calls. If you had 1,000 shares of the SPY, then I would suggest buying only 10 or 20 SPY calls.
This would allow you to continue to have upside exposure while significantly lowering risk. And you want to buy options when volatility is low, as it is now.
For those of you who can't or don't want to sell your stocks, then buying at-the-money SPY puts actually gives you the same risk profile.
That hedges risk while maintaining the upside exposure. Consider it a kind of "inexpensive" insurance that is priceless if we do get a significant drop.
(Chart courtesy of iVolatility.com)
HOW CAN I ENROLL IN optionMONSTER ADVANCED EDUCATION?
As market makers, Jon ('DRJ') and Pete Najarian schooled countless young professionals. Now optionMONSTER offers a unique education program designed and led by our co-founders.
- Learn at your speed, one-on-one
- Gain from strategies and the Greeks
- Cut out common mistakes
- Identify and refine your trading style
To get started now, help us understand your investing goals. optionMONSTER will follow up with a private phone interview.
In consideration of your time, we'll send a free trading primer authored by Jon and Pete.