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In
the last edition of the Trade Secret Newsletter, we looked at
Synthetic
Option Strategies. Continuing this month with an option
article from the Montreal Exchange we understand the differences
between In-the Money, At-the-Money and Out of the Money calls.
Buying calls is generally the first strategy employed by novice option
investors. This simple and easy-to-understand strategy can be very profitable
as it provides leverage and limits the risk to the option premium. However,
it can be frustrating for the investor who pays no attention to certain
factors.
Let’s point out that call buying is a bullish strategy and it can
be used as an alternative to buying the stock itself. For only a fraction
of the capital needed to buy the stock, investors benefit from leverage
if their bullish outlook materializes. The objective of call buyers is
to maximize their return on investment.
Before entering into any purchase, investors must determine: the
amount to invest, the target price for the underlying stock and the time
horizon inside which they think the stock will hit the target price.
The amount to invest clearly depends on the size of the investor’s
portfolio and his or her risk tolerance. One has to be very careful concerning
the amount to invest because leverage can be a two-edged sword: it substantially
increases the return as well as the losses.
Depending on their target price for the underlying stock, investors must
decide which option to use among the different strike prices available:
in-the-money, at-the-money or out-of-the-money. Out-of-money options
may seem attractive since they are less expensive. However, remember
that there is a reason for this: chances of profit at expiration are
slimmer than for at-the-money or in-the-money options. There is no best
choice. The choice of a strike price mainly depends on the target price.
Here is an example to illustrate this point. On October 25, 2004, EnCana
trades at $59.95. A bullish investor considering call purchase may choose
from the following:
• December 57.50 ECA call: $3.70
•
December 60.00 ECA call: $2.15
•
December 62.50 ECA call: $1.15
If EnCana’s target price for the month of December is $65.00
and that such price is reached at expiration, the at-the-money option
will be the best choice with a 133% return compared to 103% for the
in-the-money option and 117% for the out-of-the-money option.
However, for a target price of $63.00, the in-the-money option becomes
the best choice with a 49% return versus 40% and -57% for at-the-money
and in-the-money options. In the end, if the target price is much
higher, like in our example where EnCana closed at $68.10 at expiration,
out-of-the-money
options are the most attractive with a 387% return versus 277% and
186% for at-the-money and in-the-money options.
Out-of-the-money options perform better with a substantial increase
in the underlying stock; however, if you expect a smaller increase,
at-the-money or in-the-money options are your best choices.
Bullish investors must have a good idea of when the stock will hit
their target price—the time horizon. More often, when buying
short-term options, investors may have the unpleasant surprise to see
the stock price soar but only after the expiration of the calls they
own. By buying a longer expiration, investors leave nothing to chance
and they can always get out of their position sooner if their objective
is attained.
Last, investors must carefully look at the implied volatility of
the option at the time of buying. It is reflected in the premium.
Ultimately,
we buy options when implied volatility is low and we sell options
when it is relatively high. Buying an option that has a higher implied
volatility
often means that investors will pay too much for the option in question.
And despite an increase in the underlying stock price, the price
of their call can decrease following a decrease in the implied volatility.
Source: Montréal Exchange (Mx)
| N.B.
This bulletin is offered for information purposes only. Investments
must meet each investor's objectives. Disnat does not issue any
recommendation about a product or give out any opinion on the
nature, suitability or potential value of an investment or of
any trading strategy. |
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