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A 'call' option is another instrument you may use to trade stocks which you expect to move up. A 'call' option allows you the 'right' to buy something at a fixed price for a limited [fixed] period of time. Here's a quick analogy/example...
Just around the corner from where you live, you see a house which has just been put up 'for sale', that you think will be worth more than it is today, in 30 days time. Assume the house is priced at $100,000. Now, to make money, you could of course simply pay the seller the full $100,000, and sell the house in a months time for a bit more, say $107,000, and make 7% on your money. However...
Imagine, if instead of putting up $100,000 for the house, you had the opportunity to simply buy an 'option' in the house. This 'option' gives you the 'right' to buy the house for the fixed price of $100,000 for 30 days. The 'option' is simply a piece of paper, with an agreed contract between you and the seller...
The contract states that for a fee of $1,000, the seller CANNOT under any circumstances sell the property to any other party for 30 days. He can only sell it to you, at the fixed price of $100,000. Even if the property goes up, the seller is still obligated to sell to you for the $100,000 agreed price. In exchange, you give him a check for $1,000, which he keeps. You now have an iron-clad agreement, a paper which cost you $1,000, which 'locks' in the price of the property at $100,000.
Now, assume that that piece of paper which you now have in your hand is, itself, transferable. You can transfer or sell it to any other person. In other words it is a 'tradable' option. If the price of the property goes up to $107,000, then that same piece of paper becomes worth $7,000, because it still gives the 'right' to buy the property at the agreed $100,000 price even though it is worth $107,000.
In this example, it can be seen that a traded-option which cost $1,000 has now become worth $7,000. The intrinsic value of the option has gone up dollar-for-dollar with the value of the property. You took a calculated risk. If the value of the property stayed the same, or went down in price, then you would have lost your $1,000 deposit. For this limited 'risk' you took the option, and made a substantial profit.
Options on stocks work in very much the same way...
Imagine Microsoft stock is trading at $30. You expect it to go up. If you were to buy 100 shares, it would cost you $3,000. Instead, you decide to trade an 'option'. To buy an option in Microsoft and lock in the price of $30, it costs you, say, 80 cents per share, or $80 [for 100 shares]. The option is valid for 20 days...
Now, within 20 days, you can sell the 'option' itself, which is simply a 'right' to buy Microsoft stock at the fixed price [also known as the 'strike' price] of $30...
Assume Microsoft shoots up in the next 10 days, to $33. Now, the option has a value of at least $3, because remember, you still own an option which gives the 'right' to the stock at $30. You can sell that option to somebody else [this is all done very efficiently via an options broker] for a minimum of $3, or $300 [for 100 shares].
So, you bought the option contract for $80, and you sold it for $300. This represents a profit of $220, or 275% on your $80 capital, on a stock which moved only 10% from $30 to $33. This is profit potential of options.
The above examples provide a good basic overview of how options work. Remember call options simply give the holder a 'right' to buy [without any obligation to do so] a stock for a fixed price up to a limited [expiry] time. There is a little more to options, which we will cover in a few moments [below]. To study more about options trading at this stage, it is a good idea to visit the following educational websites, which provide a comprehensive knowledge-base on this trading instrument:-
CBOE Website [click on "Buying Calls"]
One of the websites I have mentioned above is the 'CBOE' website. The CBOE stands for the "Chicago Board Options Exchange". This exchange lists all the major 'options' for the US stocks, such as Microsoft, Yahoo, Dell, Wal-Mart, etc...
If you go to that website now, move your mouse over the "Quotes" tab at the top, and then select "Delayed Quotes"...
On the resulting page, under "Delayed Options Quotes", enter the symbol for any stock, eg., "MSFT" [Microsoft] and click "Submit". The resulting page will now show a table for Microsoft 'options' which look like this...
On the top-far-right of the table, you can see the price for Microsoft stock, which is quoted at $27.73.
You will notice, the table is split into two sides...
The left hand side is for 'Call' options [I have marked this in a red box], and the right hand side is for 'Put' options. On this page, we are focusing only on 'Call' options, so, simply ignore everything on the right hand side, and focus only on the left hand side of the table, which I have marked in the red box.
You will notice firstly, a series of available 'call' options for Microsoft stock. For instance, the one at the top states "05 Dec 25.00". This basically means, if you buy this option, you have the 'right' to buy Microsoft stock at $25.00 per share, up until the 'expiry' date, which is quoted as "December 2005". The exact expiry date is the THIRD FRIDAY of the month quoted. The third Friday in Dec'05 is 16th December.
Other 'call' options are also available. For instance, the next one is the "05 Dec 27.50" call option. This basically means, if you buy this option, you have the 'right' to buy Microsoft stock at $27.50 per share, up until the 'expiry' date, which, again, is the third Friday of December 2005 [which is 16th December 2005].
Strike Prices & Expiry Dates...
So, we have a very simple table which provides the latest options for different 'strike' prices. The strike price is simply the 'fixed' price you have the 'right' to buy the stock, up until the 'expiry' date. For Microsoft stock, the strike prices are fixed at $2.50 intervals, for instance [from the above table] $25.00, $27.50, $30.00, $32.50.
You will also notice there are 'January' expiry options available. These are slightly more expensive to buy, because the expiry date is further out, allowing you more time to maintain the right to buy MSFT at a specific strike-price. The January options expire on the third Friday of January 2006 [which is 20th January 2006].
To recap, a call option provides you with the 'right' to buy a stock at a specific, fixed [or 'strike'] price such as $25.00, up until a fixed 'expiry' date. Let's now look at the options table a little more closely, and study the options 'prices' [or 'premiums']...
I have circled in red above, the 'price' of a call option, which has a 'strike' price of $27.50, and expires on 16th December 2005. As you know, the price of Microsoft stock itself is in fact $27.73. This is actually 'higher' than the strike price. In other words, you are buying the 'right' to buy Microsoft stock at $27.50 even though the actual price of the underlying asset [Microsoft stock] is trading at $27.73. Because the 'strike' price is LESS than the actual stock price, the options quote will have a 'built-in' portion of the difference of 23 cents [27.73 minus 27.50], called 'intrinsic' value...
Options Price = Intrinsic Value + Time Value
So, from the above table, the options quote [also known as the option 'premium'] for the "December 27.50" call option is 65 cents. This includes 23 cents 'intrinsic' value, and therefore 42 cents time value. The time value represents the amount of 'time' you are buying before the option expires [third Friday of December].
Remember...
Intrinsic Value + Time Value = Option Price
23 cents + 42 cents = 65 cents
Important note: If the 'strike' price [the price at which you have a right to buy] is BELOW the actual stock price, then the option will include 'Intrinsic Value' as well as time value. If the 'strike' price is ABOVE the actual stock price, then the option will NOT include any intrinsic value, but only [entirely] 'time' value.
The 'intrinsic value' is the stock price minus the strike price. So, the December 27.50 options have an intrinsic value of 23 cents [27.73 minus 27.50]. The December 25.00 options have an intrinsic value of 2.73 [27.73 minus 25.00]. The 'time value' slowly erodes to zero upon the option expiry date.
Let's look at some other available December call-options for Microsoft stock, to make this understanding completely clear...
Firstly, look at the options where the strike price is BELOW the stock price. These are the Dec 25.00 options, and the Dec 27.50 options. Remember, the stock price is $27.73, so both these options strike prices [25.00 and 27.50] are BELOW the stock price. Therefore they contain BOTH intrinsic value AND time value...
Price of Dec 25.00 options = 2.85
This includes 2.73 intrinsic value + 0.12 time value
Price of Dec 27.50 options = 0.65
This includes 0.23 intrinsic value + 0.42 time value
Now, let's look at the options where the strike price is ABOVE the stock price. These are the Dec 30.00 options, and the Dec 32.50 options. Remember, the stock price is $27.73, so both these options strike prices [30.00 and 32.50] are ABOVE the stock price. Therefore they contain ONLY time value...
Price of Dec 30.00 options = 0.10
This includes ZERO intrinsic value + 0.10 time value
Price of Dec 32.50 options = 0.05
This includes ZERO intrinsic value + 0.05 time value
Which Call Options To Trade?
If you are trading call options, follow tis simple rule: Whenever the trend index aligns together [as shown in Part 4 of this manual] and you expect a stock to move UP, you buy call-options with the strike price NEAREST to the stock price. The strike price can be slightly above or slightly below the stock price, it does not matter, as long as the NEAREST strike price is selected.
Example, if we get a signal for Microsoft stock and it is trading at 27.73, then from all of the choices of options in the table above we would choose the strike price nearest to $27.73. As you can see, this is in fact the $27.50 call option.
We also select the 'expiry' month which is closest to the current date, but must have a MINIMUM of 10 trading days before they expire. So, if today's date is 1st December 2005, then the closest options are the December options which expire on 16th December 2005. This provides us at least 10 trading days before they expire. Because the trend index strategy is a short term trading system, we normally expect our stocks to move within 10 trading days, providing ample time to profit in the options.
On the other hand, if there are LESS than 10 trading days left in an option, then we simply select the 'next' months expiry. For example, if today was 9th December 2005, then there are only around 5 trading days left before the December options expire. Therefore, we simply select the 'next' expiry month, and buy those. In this case, we would buy the "January 27.50 Call" options.
How Do We Buy/Sell Options?
In order to trade 'options' you would need an options 'broker'. There are many of them to choose from. Options are traded in fixed 'contracts', which represent 100 shares. So, one call-option contract for Microsoft shares means you have the right to buy 100 shares in MSFT for a fixed strike-price. This 'standardization' make the whole process of buying and selling very simple indeed. For example, to buy ONE contract of December 27.50 Calls, it would cost 0.65 x 100 = $65.
The example below further demonstrates this.
In the meantime, it is a good idea to view some websites, and get in touch with the brokers we have listed below. Many of them allow you to open accounts online if you wish, and also contain online 'help' for any questions you may have...
www.optionsxpress.com
www.thinkorswim.com
www.interactivebrokers.com
www.mansecurities.com
www.etrade.com
www.cybertrader.com
A Complete Trading Example...
Imagine it is 25th November, and you have just seen Microsoft [MSFT] stock alignment on the trend index charts. The stock is trading at $27.73. You go to the CBOE website, and pull up the latest options table for MSFT, focusing on the 'call' options. Now, remember the rules: You look for the option which is NEAREST to the stock price. The nearest option is the 27.50 option. So, you select this 'strike' price. Also, the closest expiry date is the December option, and there is at least 10 trading days before the December options expire [third Friday of December = 16th December].
So, you select the "December 27.50 Call Options". You check the price, which is quoted at 0.65 cents. That means $65 per contract. You decide to trade 10 contracts, which requires a capital outlay of $650.
Over the next few days, Microsoft stock makes the expected rally, and hits $31.65 per share. Remember, you still have the right to the shares at $27.50. What is more, you can sell the 'option' itself before it expires. Now, because the stock is currently trading at 31.65, there will be an intrinsic value in the option of $4.15. In other words, your option is now worth AT LEAST $4.15...
In addition, because you are selling your option BEFORE the expiry date, there is likely to be some 'time value' left in the option. You check the CBOE site again for the latest quote, and indeed the price for the same option is quoting at $4.35. This means that the option has $4.15 intrinsic value PLUS $0.20 time value. You exit your trade.
The result is as follows...
Bought 10 contracts Dec 27.50 Calls @ 0.65 = $650 Outlay
Sold 10 contracts Dec 27.50 Calls @ 4.35 = $4350 Return
Net Profit On Trade [excluding brokerage fees] = $3700 [or 569% profit]
Typical brokerage fees for the above transaction would have been $15 in, and $15 out, or $30 in total. Many competitive brokers charge around $1.50 per contract to trade. So, in the above example, trading 10 contracts to buy = $1.50 x 10 = $15. The same again for 'selling' equals a total commission [brokerage fee] of $30.00.
Next, we will take a look at how to profit with options when you expect a stock to 'fall' in price. Remember, there were two parts to our table earlier. The left hand side of the table focused on 'call' options. The right hand side focused on 'put' options. This is the subject matter on the next page...
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