Buying Calls- Understanding Options for a Bull & Bear Market Part 1
Buying Calls- Understanding Options for a Bull & Bear Market (Part 1)
Well, welcome everyone. Thanks for joining us here today. This is Ed Modla, the director of retail education at the Options Industry Council. Formally a floor trader and pit trader in Chicago and New York and then trading electronically for a number of years since. I was a broker for a while in the futures industry, now just strictly teaching and educating the investing public about the listed options markets about both the benefits and risks. We don’t give advice at the OIC, we don’t give direction, we just provide straightforward education on the product.
Today, we’re going to talk about strategies for a Bull and Bear Market. Rather simple, nothing too complex. Here’s our disclaimer; first we’ll have some calculations and examples today that will not include the cost of commissions fees or margin. Those are important costs in a live account, but we won’t include those today.
For those of you unfamiliar with OIC who are joining us for the first time, we offer free education on our website OptionsEducation.org a variety of different formats of presentation specifically the webinar program that we do every month. You can sign up for those sessions, the next one coming up we’ll be selling puts on margin in the middle of September, and then I’m doing a 3 hour presentation at the end of September that’s going to include some of the material that I go through today actually. So, a lot of material on the website and utilize the free services of the investor services team, send an email to them at email@example.com and they will answer your questions to the best of their ability.
Today, is just going to be walking through strategies. Going to go through a number of them, I don’t want to call it rapid fire because we’ll take it from the very basic level, simple level, and start to add complexity throughout. Most of the presentation is constructed for the basic level learner, but I’ll throw in commentary as usual along the way to make it interesting. Starting with calls and puts and then adding to the verticals and then getting even further into the level of complexity with the three-way spread. So, adding complexity as we go, let’s jump into it.
First, on the simple side with buying options, so we’re talking bullish and bearish strategies. The most simple place you can start are the outright trades, super simple to understand as compared to buying long stock and owning shares. If you own shares at $60, you make money above $60, you lose below $60 and you can hold those shares as long as you want. If you’re buying a call option, you pay a premium up front and you need to retrieve or recover that premium before you profit. So, in the example, we have here buying the $60 strike for $3 at expiration, the stock would have had to move higher.
By three dollars, or in this case five percent, before we reached our break-even point then we can start to profit. That’s a significant cost to incur increasing the break-even point by that amount. However, are upfront cost is a lot less. Instead of $6,000 on a hundred shares were paying $300 and that’s our maximum loss, should we go wrong. That’s the reason to buy calls versus stock, the lower capital requirement out front and the similar risk profile once the stock starts to move. It’s not easy to make money buying options, I’m going to say that right up front. There’s a time and a place for it. But, to be profitable on a trade like this, and you’ll see call buying incorporated in some of the more complex strategies that we’ll get to later on, you have to be correct on your market direction outlook and the magnitude of that outlook in the timing of when that’s going to happen.
It’s not easy to line up those three pieces and be correct, and that may lead you to believe that these option buying strategies would be reserved for the situations where you have more confidence at your more high confidence levels, you might be looking to buy options to profit. If you are correct and you buy options and it works out in your favor the percentage returns can be extraordinary and they can work out really well for you. But, difficult to do, it’s hard to have a high batting percentage when you’re buying options and trying to make money.
You also have to understand the effects that outside forces have on the pricing and when we get through calls and then next puts, I’ll discuss volatility. Certainly earnings plays a huge role in how options are priced, with the possibility of future movements of the stock, and I’ll use a few examples of investors that I’ve either spoken to or worked with our investor services team as they retrieve and receive questions from investors.
Just yesterday, Tuesday, they talked to the investor services team. They heard from a guy who had purchased call options on Monday as an earnings play stock, was trading around $33 dollars a share after earnings were announced Tuesday morning. Before the bell, stock opened up over 5% higher and the call options were slightly negative. He was slightly in the red on his call options and of course furious. What happened? How is this possible?
Well, certainly we know when an earnings announcement is released, there is a volatility crush, implied volatility gets crushed. And the magnitude of that volatility crush is going to offset any gains you might experience from delta or the movement of the stock higher. It’s an important concept to grasp, the stock moving 5% higher had a positive influence on his call option. However, the volatility crush which was enormous more than offset that positive influence and left him in a negative position. I took a quick peek at this stock is trading $35, but the 52-week high low was around $49 to $23. It was huge. So, it wasn’t a too big of a surprise that the options are pricing in that large of movement. Another quick look back at previous earnings dates and I had seen this underlying move 10, 12, 15 percent after previous earnings announcement.
Five percent was kind of a non-events for this underlying. And this call buyer who saw what he thought was an ice pop in the stock actually was sitting on a loss, and it’s important to understand that it’s not just about the stock moving higher. You also have to pay attention to upcoming events, the earnings calendar, and any potential for volatility drops to work against you.
This is going long – a call option – buying a call for a bullish trade. You might think well wouldn’t the opposite, selling a call, be the bearish trade and while that’s true I’m not going to get into that today. I’m not going to emphasize selling call options. We’ll have protected sales of call options later on, but selling an outright call option is the most risky options trade anyone can do. If it’s not protected, you have theoretically a limitless potential loss. That’s something that can be managed from one day to the next, but if you’re holding a position over night or over the weekend there is from educational perspective no limit on how much you can lose. So, selling an outright naked option is not really looked at as a bearish play. The risk-reward there doesn’t turn out to be favorable enough to consider that a bearish strategy.