Buying Equity Call Options

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1 Buying Equity Call Options Presented by The Options Industry Council OPTIONS

2 Equity Call Options Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained by contacting your broker or The Options Industry Council at One North Wacker Drive, Chicago, IL In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.

3 Presentation Outline Call features Buyer motivations Profit and Loss profile Long call benefits Premium features Specific long call scenario Exercising Your forecast trade-offs

4 Equity Options Are American-Style Contracts An equity call buyer (owner) is long the contract Call owner has the right to buy usually 100 shares underlying stock at the strike price (per share) if exercises the contract at or before expiration Long call contract may be exercised at any time before it expires.

5 Equity Options Are American-Style Contracts On the other hand An equity call seller (writer) is short the contract Call writer has the obligation to sell usually 100 shares underlying stock at the strike price (per share) if assigned on the short contract at or before expiration Assignment is possible at any time before the short contract expires

6 Buying an Equity Call Long equity call is a bullish position Call owners do not enjoy rights of shareholders voting on corporate issues receiving dividends Call buyer s motivations? speculation profit from increase in underlying stock price, OR stock purchase intention of purchasing underlying shares after exercise What does it cost? call purchase price x $100 = total premium

7 Buying an Equity Call Potential profit unlimited with increasing stock price until expiration Potential loss limited to premium paid for call no matter how low stock drops whether option exercised or not Break-even point at expiration call strike price + premium paid

8 Open vs. Close Buying a long call opening purchase transaction hold (own) call in a brokerage account creates new position conveys rights Selling a long call closing sale transaction liquidates position voids rights to realize a profit to stem a loss on any trading day if call has market value

9 Key Benefits of Call Buying Lower cash outlay than buying 100 shares Leverage higher percentage profits possible, but higher percentage losses possible Known risk insurance less downside risk than buying shares Action on forecast stock price increase within given timeframe

10 Important Decisions Before Buying How much cash to risk? Strike price how bullish are you? Expiration month what s your timeframe? Forecast have one don t just hope

11 Call Buyer s Options Sell the contract to take a profit or stem a loss until its last trading day (before market closes) Exercise the contract pay cash for 100 underlying shares most often at expiration early exercise usually for dividend payment Let expire out-of-the-money rights expire loss = premium paid

12 Long Call Features Call is in-the-money strike price less than stock price Call is at-the-money strike price same as stock price Call is out-of-the-money strike price greater than stock price Premium features intrinsic value = in-the-money amount time value = premium in excess of intrinsic value

13 Long Call Premium - Example Buy XYZ June 60 call at 3.50 XYZ stock at $62 Call Is In-the-Money Stock Price = $62.00 Strike Price = $60.00 Time Value = 1.50 Intrinsic Value = 2.00 Total option premium (or price) = 3.50 Total premium paid = 3.50 x 100 shares = $350 (premium paid by buyer is non refundable)

14 After Call Purchase Before Expiration Greatest effects on call s value Changing stock price stock generally positive effect stock generally negative effect Volatility volatility generally negative effect volatility generally positive effect Time Decay generally negative effect increases as expiration nears

15 Ready to Buy? Before placing order, know the following: Underlying stock and option symbol Expiration month and strike price Order price limit order market order Back-up plan exercise? when to sell if stock goes up what to do if market goes against you

16 Into the Market It is mid June - XYZ price $63 Your forecast expect XYZ above $70 in 2 months Action Buy 1 XYZ Aug 65 call at 2.40 Total premium paid 2.40 x 100 shares = $240

17 Profit and Loss - Expiration Long 1 XYZ Aug 65 call at Profit Profit Potential = Unlimited Loss { 65 BEP Maximum Loss = $240 (net premium paid) (stock at or below strike) Break-Even Point = $67.40 (BEP)

18 Profit and Loss - Expiration Long 1 XYZ Aug 65 call at 2.40 If Long Call Sold For Intrinsic Value Stock Price at Expiration Intrinsic Value of Long 65 Call Total Profit/(Loss)* (2.40) (2.40) (2.40) * Profit and Loss calculations do not include commissions At expiration call worth intrinsic value, if any

19 Partial Loss - Expiration Long 1 XYZ Aug 65 call at 2.40 If Long Call Sold For Intrinsic Value But Less Than Premium Paid Stock Price at Expiration Intrinsic Value of Long 65 Call Total Profit/(Loss) 0 (.40) (.90) (1.40) (1.90) (2.40) At expiration call worth intrinsic value, if any

20 At Expiration Long 1 XYZ Aug 65 call at 2.40 vs. 100 XYZ purchased at $63 Stock Price at Expiration Option Profit/(Loss) Option % Profit/(Loss) Stock Profit/(Loss) Stock % Profit/(Loss) % % % % % % % 65 (2.40) (100%) % 60 (2.40) (100%) (300) (4.76%) 55 (2.40) (100%) (800) (12.70%) Leverage at work

21 If Call Exercised Expiration or Before Long 1 XYZ Aug 65 call at 2.40 If XYZ Aug 65 call exercised 100 XYZ shares purchased at $65 per share Net purchase price: strike price + call premium paid $ = $67.40 per share $6,740 total

22 After Call Purchase Before Expiration Buy 1 XYZ Aug 65 call at 2.40 XYZ at $63 Effect of Volatility All other pricing factors remaining constant One day after purchase volatility increases 10% call price: One day after purchase volatility decreases 10% call price: Changing volatility affects time value

23 More on Volatility Implied volatility driven by supply & demand influenced by investor s expectations, earnings, etc. not necessarily reflects stock volatility unexpected profit or loss before expiration At expiration volatility not a factor option has intrinsic value or not profit/loss dependent on accuracy of forecast

24 After Call Purchase Before Expiration Long 1 XYZ Aug 65 call at 2.40 XYZ at $63 Effect of Time Decay All other pricing factors remaining constant From 60 to 40 days before expiration call price: From 40 to 20 days before expiration call price: Time decay affects time value

25 More on Time Decay Decay of At-the-Money Call Decay of In-the-Money or Out-of-the-Money Call At-the-money calls rate of decay not linear increases as expiration nears In- or out-of-the-money calls rate of decay more linear

26 Exercising To exercise an equity option notify your brokerage firm any day up to option s last trading day within specific timeframe each day brokerage firm notifies OCC Exercise at expiration by OCC equity options in a customer account exercised in-the-money by $0.25 or more unless instructed not to do so thresholds may be brokerage firm specific Once OCC notified, exercise irrevocable

27 Early Call Exercise At call owner s discretion, but commonly to receive dividend paid to underlying shareholders during corporate action e.g. to tender shares Exercising to receive a dividend must own shares to receive dividend notify brokerage firm on day before ex-dividend date generally in-the-money calls near expiration dividend amount more than call s time value

28 Forecast is Important How Bullish Are You? In-the-money bullish but conservative substitute for buying shares less stock price increase needed for profit At-the-money moderately bullish more speculative as likely to expire out-of-the-money as in-the-money Out-of-the-money bullish speculative farther out-of-the-money, more bullish more stock price increase needed for profit

29 Forecast is Important What s Your Timeframe? Choice of expirations generally 4 available months trade-offs Short-term calls same strike - cost less less time for stock move faster time decay Far-term calls same strike - cost more more time for stock move slower initial time decay

30 In Summary Long call is a bullish position Advantages of the long call predetermined level of risk theoretically unlimited profit potential leverage with investment capital Disadvantage potential loss of entire premium paid Volatility increase is positive, decrease is negative Time decay negative Success depends on accurate forecast

31 Thank you for attending! OPTIONS

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