By Gary, on October 9th, 2012
Let’s revisit Puts and Calls. We talked about this back on December 8, 2011. I think it’s time to expand on the subject with some different strategies and additional examples.
Go here for a refresher on the definitions if you haven’t used a Put or a Call in your investment strategies.
Ok, let’s expand upon the subject.
If you need some encouragement, buying Puts and Calls can definitely make more profit for you than if you buy the stock at face value. There is some risk, but you should not be in the equity market if you are afraid of risk. How does doing this make more profit? See the example below.
Let’s explain. First of all you will need to sign an Option contract with you broker. This authorizes them to act on your behalf to buy or sell stock at a reference price during a set time frame.
This time we will tackle the Option to Call (or Call Option).
Let’s say you and or your broker have been tracking a company for some time and the stock value is at an all-time low, but shows signs of recovery. You could just buy some shares and watch it go up, sell the shares and take your profit. That is the normal scenario.
So – normal scenario: Buy 100 shares of ABC stock at $49 per share. Your out of pocket is $4,900. In six months’ time, the value of the stock climbs to $57 per share but still looks like it could go higher. At six months, your broker calls and recommends you sell and pocket the $800. You are happy because you just made 16% on your money in six months. That’s pretty good.
Instead of the normal scenario, what if your broker called and recommended you purchase a Call Option. You both think the stock value for ABC will rise, so it’s just a matter of deciding the strike price and the time frame. After some discussion, it is decided to buy the option with a strike price1 of $50. Let’s say that the call option costs $2/share and the option covers 100 shares. Your out-of-pocket is $200. The time frame is set for four months.
So – call option scenario: Buy one call contract for 100 shares of ABC at $2 per share with a strike value of $50 per share at a time limit of four months. Your out of pocket is $200. After two months ABC stock has reached $54 per share. You call your broker. You tell them to exercise the right to purchase the stock at $50 per share and then sell it at $54 per share for a $200 profit ($4 x 100 – $2 x 100 = $200). You made 100% profit in two months. “Not so fast” says your broker. He has a buyer for your call contract. The buyer wants to buy your call contract for an extra $1.50 per share thinking the stock value will go even higher than $54. How does that work?
The buyer purchases your call contract for an additional $1.50 per share. The buyer now owns your call contract for the remaining two months, anticipating the stock to still go up. You now have made $350 in two months instead of $200. How? You sold the option like this:
Valuation $54 – $50 = $4.00
Less Purchase = $2.00
Plus Option Sale = $1.50
Your Value after Sale = $3.50
So – at $3.50 per share you have a $350 profit in two months. This is a 175% profit while the stock price has increased 11% in the same two months.
That’s a quick explanation of buying a call option, selling a call option and making a quick profit while not using up a lot of your hard earned money.
Next time we will explain what happens when, heaven forbid, the stock goes down and not up during your call option.
1 Strike Price – The starting share value of the option contract. For a call option, the strike price should be either at or above the current stock price for the company. If it is below that value, no call can be made.