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Geoff Garbacz James DiGeorgia

Advantages of Call Options Over Stock

October 1, 2007

Advantages of Call Options Over Stock

 We're going to take a specific example with call options to further show you the advantages of options over stock.

 Before we continue, let's review the properties of a call option. A call option gives the owner the right, not the obligation, to buy 100 shares of stock for a fixed price through a given time period. In our beginning options courses online, we often compare a call option to pizza coupon. A pizza coupon, as everyone knows, provides a right to buy pizza. It is not an obligation. It also allows you to pay a fixed price for specific deal (number of pizzas, size and toppings, etc.) through some expiration date. This is essentially the idea behind a call option. It allows the holder to buy 100 shares of some underlying stock through the third Friday of the expiration month. Unlike pizza coupons though, call options must be paid for but the idea behind their mechanics is essentially the same.

 Why would someone sell such a "coupon?" There are several reasons. First, speculators may simply sell a call option on a hunch that the stock's price will fall. If they are correct, they will profit by a maximum amount of the premium collected from the sale of the call.However, if they are wrong, they will continue to lose money as long as the stock's price rises sufficiently. The reason is that the speculator is bound by an agreement to sell shares of stock for a fixed price — shares he doesn't own. If the stock's price rises sufficiently, he may have to buy shares in the open market at a high price and deliver them for a lower price to the person who bought the call option leaving the speculator with unlimited loss potential.

 Second, you may get investors selling calls against shares they currently own. This is the "covered call" strategy where the seller collects the premium for selling the call but, unlike the speculator, is not at risk of rising stock prices since he is always able to deliver the shares at a known cost. There are other strategies where investors can sell options without risk of rising prices but they are too numerous to cover here. The point is that there are many types of people with various reasons for selling calls.

 You, as the buyer of a call, have the right to purchase shares of stock at a fixed price. In exchange for that right you must pay the seller a premium which is dictated by market forces. Should you decide to use the call option to buy shares there is no counterparty risk since all transactions are guaranteed by a clearing corporation called the Options Clearing Corporation (OCC). This just means that if you decide to use your call option and buy shares you do not have to worry about the other party defaulting on their obligations. The OCC assures that all transactions will go through. Because of this guarantee, the ownership of the call is, in a lot of ways, like owning the stock. It gives you the right to
buy stock but you do not have to pay for that stock just yet. Instead, you pay a small fraction of the stock's price for the call option and then decide if it is advantageous to use that option. Of course, it will only be advantageous to use that call if the stock's price is greater than the "coupon price" (called the "strike" price) at expiration. Why wait until expiration? The reason is that you do not want to pay for the stock earlier than you have to. Because you have all the way until expiration, it is to your advantage to wait that long before "using your coupon" and purchasing the stock.

 If you exercise your call to buy stock, you will profit by the difference between the stock price and strike price. For example, if you buy a $50 call and the stock is $55 at expiration then you are better off by $5, which is the difference between the stock's price and the strike price. You get to buy stock worth $55 by paying only $50. Consequently, the market price of this $50 call must be $5 at expiration. So whether you decide to exercise the call or simply sell it back to the market you will profit by the same amount.

 This does not mean that you must wait until expiration to profit from a call option. If the stock's price rises sufficiently while you are in possession of the call option you cansimply sell the call to another investor. You will always receive more money from this method rather than using it to buy stock for the fact that time still remains on the option.And as long as time remains, investors will pay a premium for that call option. For instance, assume you purchased the above $50 call for $2 and the stock is $55 prior toexpiration. If you exercise the call, you will receive stock worth $55 and pay $50 for a gain of $5 (a profit of $3 after subtracting the $2 cost). However, the $50 call must be worth the $5 intrinsic value plus some additional value since time remains on the option. This option may, for example, be trading for $6. So if you exercise your call you are
better off by $5 but if you sell it you are ahead by $6. It is easy to see that the right decision is to sell the call in the open market.

 If you are buying call options as a substitute for stock, it is advisable to buy an in-themoney call which means that the strike price is less than the stock's current price. For instance, if the stock is $55, you might consider a $50 call. Technically speaking, we'd like to buy a call that responds to the stock's price by about 80 to 85 cents on the dollar, which is to say that it has a delta of 0.80 to 0.85. These delta figures can be obtained from any options broker or from numerous free websites such as www.888options.com. These options will behave about like a stock, cost far less, and have a defined limited loss
potential. But in addition to those benefits, there is another. That is, if the stock's price starts to fall, you'll find that the call option will lose money at a slower rate than that of the stock. The reason is that as the stock's price gets closer to the strike price the time value increases and that acts to offset the losses.

 The examples highlighted above show some of the biggest advantages for owning call options. First, you only pay a small fraction of the stock's price to control shares of stock.By paying a smaller fraction, you now have more money to invest in other areas to diversify your holdings. Alternatively, you can put that money aside to earn interest.Second, the most you can lose with a call option is the amount paid which, again, is far less than the cost of the stock. Third, because of the time premium though, if the stock's price should fall the call option will lose money at a slower rate.

 So the basic advantages of an in-the-money call option over stock are:

1) Behave about like the stock but cost far less

2) Have a defined limited loss potential

3) Lose money at a slower rate if the stock price falls

 Options were originally created to hedge or avoid risk. By purchasing or selling options, you can custom tailor the profit and loss profile of your holdings which is something that long stock holders cannot do. Ironically, it is the investors who do not use options that are taking the greatest risks of all. They are holding all of the downside risk in exchange for 100% of the upside potential profits. Option traders, on the other hand, can reject some risks in exchange for sacrificing some upside profits. But after reviewing the past five years, most stock investors should agree that this is a worthwhile tradeoff.