In our last Trade Secret Newsletter, we discussed Short Selling Strategies. In the following article from the Montreal Exchange we look at Why Investors Buy or Sell call options.

Why Do Investors Buy or Sell Call Options?
In his book Options as a strategic investment, Lawrence G. McMillan points out that “The average person dealing in option trading utilizes primarily one of two option strategies—call buying or covered call writing.” It is worth examining why.

Two of the primary reasons for buying call options are the high potential leverage and the limited risk. High leverage, since the investor stands to benefit from an increase in the value of the underlying stock while investing only a fraction of the capital needed to purchase the stock outright; limited risk due to the fact the maximum loss is the premium paid.

The criteria for selecting a particular stock upon which to buy calls options is a matter of personal choice. The decision to buy call options on a particular stock is a reflection of the investor’s belief that the stock will rise in value. Once a particular underlying stock has been selected, however, the investor still has to select a particular series.

The choice of an option series is primarily a function of two variables related to the forecasted rise: timing and magnitude. That is, when will the stock price rise and by how much. An investor will only be certain to resell his option at a profit if the forecasted rise in the price of the underlying stock occurs before the expiration of the call option.
These two factors—magnitude and timing—determine, respectively, the strike price and the expiration month to be selected. The specifics vary with the particular strategy, but, as a general rule, many investment advisors recommend the following principles. Note that these guidelines are based simply on general experience and are not necessarily applicable in all circumstances.

• The shortest-term option series is not usually purchased unless the investor is very confident of an immediate rise in the stock value. The time value of options with short maturity depreciates quickly. The price of the stock may move, but after the option’s expiration.
• Therefore, positions with less than six weeks to maturity ought to be examined closely for resale value. That is, it is often best to resell call options with less than six weeks to maturity and roll forward (i.e. buy) to options with a more distant expiration month.
• Deeply out-of-the-money options are generally acquired only if a very large move in the price of the stock is expected. Deeply out-of-the-money series require large percentage increases in the value of the underlying stock in order to break even. Remember, there is a reason the out-of-the-money option premium seems so low: the chances of profit are slimmer.

Some investors consider call writing as an occasional investment practice. Others consider call writing as an important investment activity, if not the most important one.

Recall that call options writers are paid a premium for undertaking the obligation to deliver the underlying security at the contract’s strike price if the option buyer exercises his option before or at expiration. Thus, in one sense, the writers are risk-takers in the stock options market: in return for a one-time revenue flow, the writer risks the possibility of having to sell the underlying stock at a price well below prevailing market rates.

Since stock options are American style, call option writers must keep in mind one basic point: an option may be exercised and the writer called upon to deliver the underlying security for the strike price at any time prior to the expiry date. The decision to exercise an option and the timing thereof rest solely with the option holder. Although unusual, some call options are exercised days, weeks or even months prior to the expiry date (especially before the ex-dividend date).

A writer cannot predict with certainty the date on which an option will be exercised. However, the chances of the option being exercised are greater when the premium is almost exactly equal to the intrinsic value of the option. This occurs when an option is deeply in-the-money and/or near expiration.

If a writer does not want to be called upon to deliver the underlying security, he may effect a closing transaction prior to the exercise of his option. A closing transaction is effected by purchasing an option identical to the one the writer has previously sold to close the position.

Call option writers may write the options “against” positions already held in the underlying stock or they may be “uncovered” writers. The uncovered writer is prepared to take additional risks in the hope of making larger profits. For this reason, uncovered writers must maintain a minimum margin deposit with their broker.

The major reasons for writing covered options are to reduce the purchase cost of the underlying value, to profit from a moderate increase of the price of the underlying, to provide an alternative to a limit sell order, and to increase the return of a portfolio. In writing covered or uncovered options, the writer is said to be “short” the call option so long as the option (series) he has written is still trading and he has not repurchased it.

The risks taken by each option contract participant will depend upon each party’s investment goals and their evaluation of the risk/return ratio of each investment. By spreading the risks and profit opportunities inherent to stock ownership, the option market provides investors with alternatives not otherwise available except by completely overhauling their portfolios. Once again, options help transfer risks between investors who want to reduce their risk and those who want to assume risk in return for potentially higher profits.

Previous Newsletter

• January 2005 - Mastering short selling
• December 2004 - Covered call writing
• November 2004 - Gain insights on Exchange Traded Funds.
• October 2004 - Features of the Recognia Inc.
• September2004 - What is Technical Analysis?