Chapter 2-1 Single-Leg Long Strategies

Single-leg long strategies are the most basic of all options trading strategies.  These strategies are executed simply buy buying an option.  There are many reasons why investors choose to buy options; the most common of these are speculation and protection.  Investors use options to speculate on the directional moves of the underlying asset by buying puts and calls depending on where they think the stock is heading.  If investors think a stock is going to appreciate, they can buy a call option instead of buying the stock.  Likewise, if investors think a stock is going to depreciate, they can buy a put option instead of shorting the stock.  In both cases the investor owns something- the right to buy or sell, hence the long part.  The following section will cover the risks and rewards associated with option buying and provide examples to aid your understanding.

Buying Calls

You want leverage? Buying calls gives you leverage over 100 shares of an underlying stock (or ETF) at the strike price until the expiration date.  Long calls are used to speculate and profit from upward moves in the underlying asset.  For many investors this is the primary appeal to options, particularly when considering high priced (and therefore capital intensive) securities.

For example, the GOOG December 500 call option gives you the right to buy 100 shares of GOOG for $500 per share until the expiration date in December.  You would do this with the expectation that the price of the option will rise, usually through an increase in the price of the underlying stock.  Let’s say you purchased the GOOG 500 call option for $25 when the stock was trading for $500.  If GOOG goes up to $550 before expiration, then your call is worth at least $50.  This gives you a 100 percent return on the call option based on a 10 percent return on the stock.  This disparity clearly demonstrates the power of leverage when buying options.  Conversely, if the stock does not move up then the option will lose all of its value and expire worthless because there is no intrinsic value.  This is caused by the decay of the time value portion of the option’s premium, known as time decay.  The previous example illustrates the risk associated with buying calls.  Calls are expiring assets; they have time value that diminishes over time.  However, regardless of how far the stock falls your maximum risk is limited to the cost of the call.

Consider the following table to help clarify the risk and reward of purchasing call options:

GOOG

Stock Profits/Losses

% Return

Call Profits/Losses

% Return

$200

-$300

-60%

-$25

-100%

$500

$0

0%

-$25

-100%

$550

$50

10%

$25

100%

$600

$100

20%

$75

300%

This can be shown graphically:

option-content-image-2-1-1


Exiting Long Calls

Long call positions can be closed in one of three ways:

  • Selling the call – Once an option has been purchased it can be sold at any time, just like a stock.  This is the most common way of exiting a long call position and the only way of exiting a long call position that captures any remaining time value.  Your profit or loss will be based on the difference between the premium paid and the premium received.
  • Letting it expire – If a call gets all the way to expiration and is out of the money (when the strike price is above the stock price) it will expire worthless.  If the stock price is above the strike price by $.01 or more it will be exercised automatically and shares will be delivered to your brokerage account.  Long calls are almost always sold before expiration because at expiration they will have no time value and thus carry the smallest premium possible.
  • Exercising your call – Utilizing the right to buy provided in the call contract is known as “exercising” the option.  This results in your brokerage delivering shares of the stock to you for purchase at the strike price.  Although this was their original intention, options are rarely bought with the intention of exercising the underlying right.  Similar to letting an option expire, taking this course of action also forfeits any remaining time value in the option.

Buying Puts

Want to profit from moves to the downside? Puts give the buyer the right to sell a specific number of shares (usually 100) of an underlying stock at the strike price until the expiration date.  Long puts will be profitable if the underlying price falls.  Buying puts offers a risk-limited way to profit from downside moves in an underlying asset, unlike short selling where the risk is theoretically unlimited.  Due to their inverse nature, puts are also a popular way to protect positions as insurance (when used in such a manner they are referred to as Protective Puts).

The following example shows how to correctly utilize put options when a downside move in Google is anticipated.  To capitalize on this down move, you purchase the GOOG 500 put option for $25 when GOOG the stock is trading at $500.  If GOOG goes down to $450 before expiration then your put is worth at least $50.  This gives you a 100 percent return on the put option with a 10 percent loss on the stock.

Consider the following table to help clarify the risk and reward of purchasing put options:

GOOG

Stock Profits/Losses

% Return

Put Profits/Losses

% Return

$400

-$100

-20%

$75

300%

$450

-$50

-10%

$25

100%

$500

$0

0%

-$25

-100%

$600

$100

20%

-$25

-100%

This can be shown graphically:

option-content-image-2-1-2

In addition to speculation on price movements, buying puts on a stock you own can provide insurance on that position.  In a similar fashion, index puts can be used to insure your entire portfolio.  In this way buying puts is very much like buying insurance: you pick the deductable and the premiums.

Exiting Long Puts

Long put positions can be closed in one of three ways:

  • Selling the put – Once a put is bought it can be sold at any time, just like a stock.  This is the most common way of exiting a long call position and the only way of exiting a long put position that captures any remaining time value.  Your profit or loss will be based on the difference between the premium paid and the premium received.
  • Letting it expire – If a put gets all the way to expiration and is out of the money (when the strike price is below the stock price) it will expire worthless.  If the stock price is below the strike price by $.01 or more it will be automatically exercised and shares will be “taken” from your brokerage account.  Long puts are almost always sold before expiration because at expiration they will have no time value and thus carry the smallest premium possible.
  • Exercising the option – Utilizing the right to sell provided in the call contract is known as “exercising” the option.  This delivers shares of the stock from your account at the strike price.  Although this was their original intention, options are rarely bought with the intention of exercising the underlying right.  Similar to letting an option expire, taking this course of action also forfeits any remaining time value in the option.

Rules of Buying

Regardless of whether you are buying calls or puts there are some general rules to follow.  For starters, the expiration date should give the option enough time to perform without being overexposed to time decay.  Since options are expiring assets a large part of their value is time value. Time value deteriorates as expiration approaches and time decay increases exponentially in the last 30 to 45 days of an options life.  As a result, this is usually not the time to own options.  Second, options should generally be bought when the time value – primarily influenced by a factor known as implied volatility, or the expected price swings of the underlying – is expected to stay flat or to rise.  Buying options is a limited-risk strategy with all of the risk lying in the premium paid for the option.  All else equal, if implied volatility increases then there will be a rise in the option premiums.  This increase can produce profits for long options even if the stock price does not move because the chance of movement has increased.  Conversely, if you buy options when implied volatility and premiums are high, such as before earnings, then the stock can move in the direction that you want and you can still lose money.  This occurs because the implied volatility could fall after the news is released.  Finally, when you buy an option you should be doing so with the expectation that you will want to sell it, ideally for a still-greater premium.  You do not want it to expire since you will receive zero premiums, and normally you do not want to exercise your right to purchase the underlying shares unless that is your particular strategy (say for tax reasons).  In both of these cases you lose whatever time value is left in the option.  Consequently, with future resale value in mind we can see why risk management rules, such as taking profits when your position doubles or closing out the position when it loses half of its entry value, are important.

The most elementary use for options is to profit from stock price gains with limited risk and lower cost than an outright stock purchase.

Example:         You buy one Intel (INTC) 25 call for $1 while the stock is at $25.

INTC moves up to $28 and your option gains at least $2 in value, giving you a 200% return versus a 12% increase in the stock price.

Similar to the above example, some investors use options to profit from stock price drops with limited risk at a lower cost than shorting the stock.

Example:         You buy one Oracle (ORCL) 20 put for $.80 while the stock is at $21.

ORCL falls to $18 and you have a gain of $1.20, giving you a 150% return versus a 10% decrease in the stock price.

Questions