Buying a call option gives
you the right (but not the obligation) to purchase 100 shares of a company’s stock
at a certain price (called the strike price) from the date you buy the call
until the third Friday of a specific month (called the expiration date).
People buy calls because
they hope the stock will go up, and they will make a profit, either by selling
the calls at a higher price, or by exercising their option (i.e., buying the
shares at the strike price when the market price is higher).
Call options are quoted in dollar terms (e.g., $3.50), but
they actually cost 100 times the quoted amount (e.g., $350), plus an average of
$1.50 commission (charged by my discount broker — commissions charged by other
brokers may differ).
Since most stock markets go up over time, and most people
invest in stock because they hope prices will rise, there is more interest and activity
in call options than there is in put
options.
Real World
Example of Call Options
Here are some call option prices for a hypothetical XYZ
company on November 1, 2010 (price of stock: $45.00):
Expiration Date
Strike Price
Nov '10
Dec '10
Jan '12
Terminology of Option (price of call option)
40
$5.50
$7.00
$18.50
"in-the-money" (strike price is less than stock price)
45
$2.00
$4.00
$16.00
"at-the-money" (strike price is equal to stock price)
50
$0.50
$1.00
$14.00
"out-of-the-money" (strike price is greater than stock price)
The premium is the
price a call option buyer pays for the right to be able to buy 100 shares of a
stock without actually having to shell out the money the stock would cost. The
greater the time period of the option, the greater the premium.
The premium (same as the price) of an in-the-money call is
composed of the intrinsic value and the time
premium. (I understand that this is
confusing. For in-the-money options, the option price, or premium, has a
component part that is called the time premium). The intrinsic value is the
difference between the stock price and the strike price. Any additional value in the option price is called
the time premium. In the above example, the Dec ‘10 40 call is trading at
$7.00. The intrinsic value is $5 ($45 stock price less 40 strike price), and
the time premium is $2.
As its ticker symbol implies, Salesforce.com (CRM) provides cloud solutions for customer relationship management needs. CRM reported earnings in late August that blew away expectations on both the top and bottom lines. The report was met by the usual round of target price increases that reached as high as $340 (CRM closed at $260 on Friday).
The stock gapped higher after the report and extended as much as 5.5% higher the next day, eventually closing with a 2.5% gain. But the shares then sagged, joining the rest of the market in the early-September swoon. In fact, CRM fell more than 8% from its post-earnings high.
But the shares appeared to find a bottom last week, thanks to the support of the 50-day moving average. Since turning higher in May, the 50-day has supported pullbacks in July and August. CRM has been stepping higher since a low in early March, putting in a series of higher highs and lows in a rally that has covered nearly 30%. This trade is relying on this trendline support holding for the next six weeks, as the short 250 put of our credit spread is just below the 50-day.
Sell to Open CRM 29Oct 250 put (CRM211029P250) for a credit of $1.10 (selling a vertical)
This credit is $0.02 less than the mid-point of the option spread when CRM was trading at $260. Unless the stock rallies quickly from here, you should be able to get close to this amount. Your commission on this trade will be only $1.30 per spread. Each spread would then yield $108.70. This trade reduces your buying power by $500 and makes your net investment $391.30 ($500 – $108.70). If CRM closes above $250 on October 29, both options will expire worthless and your return on the spread would be 27% ($108.70 / $391.30).
Copart (CPRT) provides online auction and vehicle remarketing services in the U.S. and several other countries. On Wednesday, the company reported Q4 earnings that easily beat on the top and bottom lines. Used car prices are soaring and CPRT is positioned perfectly to leverage the market. Analysts seem to agree, as CPRT received several target price increases that ranged up to $165 (CPRT closed at $143 on Friday). Despite the positive news, the stock fell as much as 5% on Thursday before closing 2% lower. However, CPRT gained more than a percent on Friday amid a down market.
The stock has been in rally mode since late March, gaining more than 30%. The 50-day moving average has been instrumental in guiding the uptrend, containing pullbacks in May, June and August. The trendline appears to be doing its job again, as it supported this week’s post-earnings drop. This trade is relying on this support holding for the next five weeks as the short 140 put of our credit spread is just below the 50-day.
If you agree that CPRT will stay above the 50-day moving average (red line in chart), consider the following trade that relies on the stock remaining above 140 (blue line in chart) through expiration in five weeks.
Buy to Open CPRT 15Oct 135 put (CPRT211015P135)
Sell to Open CPRT 15Oct 140 put (CPRT211015P140) for a credit of $1.20 (selling a vertical)
This credit is $0.05 less than the mid-point of the option spread when CPRT was trading at $143. Unless the stock rallies quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $118.70. This trade reduces your buying power by $500 and makes your net investment $381.30 ($500 – $118.70). If CPRT closes above $140 on October 15, both options will expire worthless and your return on the spread would be 31% ($118.70 / $381.30).
Software developer (QuickBooks, TurboTax) Intuit (INTU) reported earnings on Aug. 24 that handily beat estimates on all fronts. Earnings came in at $1.97 per share, topping the analyst forecast by 24%, while quarterly revenue of $2.56 billion beat the estimate by 10%. The company also raised its quarterly and annual revenue and earnings guidance above expectations. To top it off, INTU raised its dividend and approved a new $2 billion repurchase authorization.
The Street clearly loved the report, as the stock was hit with several large target price increases (one raised the price 27%). The average new target price after these raises was around the $640 mark, which is 13% above INTU’s closing price on Friday.
The stock price took the news and target increases in stride, though, with no change on Thursday after the report. On Friday, the stock resumed its huge rally with a 2.4% gain. INTU is up nearly 50% in 2021, with most of that gain coming in the past 3-1/2 months. The shares have been riding along their 20-day moving average, a trendline that has not allowed one daily close below it since mid-May. The 20-day is currently at 541 but should cross above the 550 level in less than two weeks at its current pace. This is also the site of the short put strike of our credit spread.
If you agree that INTU will continue its rally along the 20-day moving average, consider the following trade that relies on the stock remaining above 550 through expiration in seven weeks.
Buy to Open INTU 15Oct 540 put (INTU211015P540)
Sell to Open INTU 15Oct 550 put (INTU211015P550) for a credit of $2.80 (selling a vertical)
This credit is $0.05 less than the mid-point of the option spread when INTU was trading at $566. Unless the stock rallies quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $278.70. This trade reduces your buying power by $1,000 and makes your net investment $721.30 ($1000 – $278.70). If INTU closes above $550 on October 15, both options will expire worthless and your return on the spread would be 39% ($278.70 / $721.30).
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Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.
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Options are not suitable for all investors as the special risks inherent to options trading my expose investors to potentially rapid and substantial losses. Please read Characteristics and Risks of Standardized Options before investing in options
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