Stock options: How to use calls as a stock substitute.

If you wish to purchase stock, you may want to consider using options as a substitute.

If you don’t know what a long call is: here is a quick tutorial.

When you buy a long call, you are purchasing an ‘option’ to purchase 100 shares per contract, at a specific strike price at expiration.

For example:

Let’s assume XYZ stock is selling at 20 dollars a share- you think it will rise to 25 dollars in the next three months. Instead of purchasing 100 shares of XYZ for 2,000 dollars, you purchase one 22 strike call that expires four months from the date of purchase. The call will cost 50 dollars. If the stock rises above 22 dollars a share before, or at expiration, you will earn the difference between the strike price of 22 and the current stock price.

Assumptions:
Current stock price: 20
Options strike price: 22
Time before expiration: 4 months

As soon as you purchase this option it is known as OTM or out of the money.
An option out of money derives its value from how much time is left, plus how close the strike price is to the current stock price, and expected volatility is the last ingredient.

In a bullish market, you may pay a premium for the OTM option because the market believes it will hit the strike before expiration. In a bearish market, you will pay less because the market is betting on the stock decreasing in value before expiration.

Incidentally, puts price volatility in the opposite direction. A put is the inverse of a call.
If you think the stock is going to decrease in value you would purchase a put.

If the stock is at 23 dollars a share you would have made 100 dollars- minus the 50 you paid for the option. If the stock is at 24 your profit would be 200 dollars.

If the stock is at 22 dollars a share or less, your option will expire worthless.

However, if the stock rises suddenly, you will be able to make back what you paid for the options plus the amount above and beyond the strike price. The reason for this is volatility. If the stock becomes wildly bullish, the options carry a premium above and beyond their stock price.

Always remember, time decay negatively affects options, and volatility positively affects them.

If the stock plummets, your total loss is the 50 dollars you paid for the option. If you owned the stock your loss could be your entire investment if the company goes bankrupt.

In a volatile market, if you are bullish, purchasing calls is a prudent strategy.