Buying Naked Calls
Buying Naked Calls
Should you buy calls? Many people say you should not, but we beg to differ. In the early days of option trading (1970s and 1980s), calls and puts were often prohibitively expensive.
That situation has definitely changed since the beginning of the 1990s. Indeed, our performance numbers suggest that even the most conservative investor should add some call purchases to their portfolios. Even when markets are volatile, it is possible to find attractively priced calls, if you know where to look.
When you buy a call, you pay a premium for the right, but not the obligation, to buy the underlying stock at a specified price - known as the strike price - until a certain specified date - known as expiration date.
What makes a call cheap or expensive? What we are really talking about is an option’s time premium. Time premium is that part of an option premium that is not "intrinsic" value. Think of time premium as insurance against making the wrong financial decision.
There are five "known" variables (stock price, strike price, time to expiration, dividend rate and interest rate) and one "unknown" (or estimated) variable - volatility - that gives an option its time premium.
More specifically, this "unknown" is the expected range or dispersion of the stock price over the life of the option. An Internet stock such as NVIDIA can be twice as volatile and have twice the time premium as a Brokerage stock such as Goldman Sachs.
Calls with cheaply or reasonably priced premiums can be very attractive investments. In terms of risk versus reward, calls can run the gamut from those that trade very much like the underlying stock to more leveraged positions that only pay off if the stock makes a big move.
An In-the-Money "Deductible"
An in-the-money call is one in which the stock is above the strike price; thus, the option has tangible value. In addition, this option has time value. This time value is insurance against the stock going below the strike price.
Think of the difference between the stock and the strike price as the "deductible" on an insurance policy and you will get the concept. The lower the strike price on an in-the-money call, the more the investor can lose and the lower will be the time premium that he or she needs to pay.
Take at look at Graph 1:
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Here we have the $12.50 strike August call on Integrated Device with the Stock at $15.00, priced at $3.05. The most you can lose on this position is this $3.05, which consists of $2.50 worth of tangible value and the option’s $0.55 time value, which is, in effect, insurance against the stock going any lower.
If you wanted to pay less for insurance, but were willing to live with the possibility of a larger loss, you could buy a call that is even further in-the-money (i.e. with a lower strike price) and that has even less time premium.
Continued In "Part Two: Your Best Call?"....
Posted By: Value Line Daily Options Survey
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