Thursday, September 19, 2013

Buying Call Options

We shall continue with the simplest strategy : Buying Call Options.  This is the simplest strategy because it is very similar to Buying Stocks or Futures or Forex.  It is easy to follow.  It is also attractive to most beginners because maximum profit potential is unlimited while maximum loss potential is limited to premium paid.

After we have established a Stop Loss method, the next question is : What is the Entry?  For Options, it is more of What Options to buy.

Say we have established a bullish view on XYZ stock.  We want to buy XYZ Options.  They are many Options available for XYZ stock.  Which one to buy?  There are 5 pieces of information you need before you can buy:
1. Underlying Stock : assume we have already decided on a bullish stock XYZ
2. Expiration Month/Dates
3. Strike Price
4. Call or Put : it will be Call since we are using Buying Call Options strategy
5. Price :

Expiration : at least 2 months
Time is a critical factor in Buying Call Options strategy.  Every day that we hold an Option, the time value of our Option will decrease.  And it will decrease at an increasing rate as we approach the expiry date.

So, we should not be buying Call Options that is expiring in near term, say in the current month.  Not only there is very little time for the price of the underlying Stock to increase for our bullish strategy to work out, the time value is going to decrease at an increasing rate as we approach the expiry date.

We are playing against time.  The price of the underlying stock needs to increase by a sufficient amount before the expiry date for us to make a profit.

Therefore, for a start, I am only going to buy Call Options that have at least 2 months till expiration.

Strike Price : In The Money (ITM) and Stop Loss price
When the Strike Price is higher than the Stock Price, our Call Options is Out of The Money (OTM).  The premium we pay for the Call Options are all Time Value.  If the Stock Price didn't increase above the Strike Price at the expiry, the Call Options time value will become zero.  The Call Options will expire worthless.  We will loss all the premium.  The Stock Price need to increase sufficiently above the Strike Price to firstly offset the premium we paid for the Option.  And need to increase even further to make profit.

When the Strike Price is the same as the Stock Price, our Call Option is At The Money (ATM).  Similarly, the premium we pay for the Call Options are all Time Value.  It will be almost the same as OTM.

Therefore, I will only buy Call Options that is In The Money (ITM) which the Strike Price is lower than the Stock Price.  In fact, I will choose the Strike Price to be the Stop Loss price where the trade is no longer valid.

In conclusion, I will only buy Call Options that will expire at least 2 months away and it is ITM with Strike Price same/close to my Stop Loss price.

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