Order Entry: Debit
Ideal Environment: Low IV
Profit Target: Arbitrary (no ideal %)
Definition: An agreement that gives the buyer of the option the right (but not the obligation) to buy a stock at a specified price and quantity on or before a particular date.
Each stock option covers 100 shares of the underlying stock.
Buying Call Options
The holder of a call option has the right (not the obligation) to buy an agreed quantity of stock from the seller of the option within a fixed period of time (until the expiration date) for a certain price (strike price).
The risk of buying call options is having the options expire worthless by the expiration date. The max loss for buying options is the premium paid to the seller of the call option.
As a buyer of the option, the trader can sell the option before the expiration date. The buyer of the call is allowed to sell the call option at a higher price for a smaller profit.
A disadvantage of buying options is negative theta decay (time value). As the option approaches expiration the time value portion of the option decreases. This is bad for the buyer of the option because if the stock does not move, the option still loses value up until expiration.
Buying OTM calls has a lower probability of success, but the ROI is higher. Buying ITM calls has a higher probability of success, but the ROI is lower. Basically, you get paid more when taking on more risk.
In order to breakeven during the purchase of an OTM call option, the price of a stock has to appreciate past the call strike price before expiration.
Breakeven = Call Strike Price + Premium Paid + Commissions
Every penny above the breakeven price is pure profit. Profit is the difference between the stock price and the breakeven point multiplied by 100 shares/contract.
Profit = (Stock Price – Breakeven) X 100 shares/contract
Even though a stock goes up and gets above the strike price, the trade may still result in a loss. This is due to the negative theta decay. The positive difference between the stock price and call strike price doesn’t outweigh the premium paid.
Partial Loss = ((Stock Price – Strike Price) X 100 shares/contract) – Premium Paid
If the stock price stays the same or goes down the option expires worthless and the trader loses the premium paid.
Max Loss = Premium Paid