Buying Calls – 3 Problems, 1 Solution

by Dan Passarelli | February 23, 2011 5:30 am

Dan Passarelli is an author and the founder of Market Taker Mentoring LLC, the home of personalized, one-on-one options education[1].

One way traders use options is to buy calls instead of the underlying stock. In comparison to the underlying, calls offer limited loss and some hefty (unlimited) profit potential. This makes for an attractive options trading[2] alternative. But there are a few problems with buying calls as a stock substitute.

Time Decay

First and foremost, long options have time working against them. As time passes, options lose value. Therefore, a long call must overcome this time hurdle.

Break-Even Point

If traders hold the call until expiration, the stock must rise to a high-enough price to cover the cost of the call, just to break even. For example, imagine a trader buys a 50-strike call for $1. The stock must rise to $51 by expiration to cover the cost of the call.

Leveraged Loss Potential

Though leverage can be considered a good thing, it has a dark side. With long options, you only lose what you pay for the option. But, that means 100% loss on investment.

Solution: The Bull Call Spread

An alternative to the long call is the bull call spread. With a bull call spread[3], a trader buys a call and, at the same time, sells a call with a higher strike price. Fore example, a trade might buy the 50-strike call at $1 and sell the 55-strike call at $0.40. That means the trader pays only $0.60 for the spread package.

There are several benefits to a Bull Call Spread compared with a straight Buy Call:

• less capital invested in the trade, so even a 100% loss is a smaller loss,
• that lower investment means the break-even price is lower,
• the underlying doesn’t have to move as far for the spread to be profitable,
• lower time-decay risk. While long options have a time-decay problem, short options have a time-decay benefit. The spread has both a long and a short call, so the time-decay risk is “hedged off”.

Though a bull call spread has limited profit potential (unlike the long call) its benefits over buying a call can be great. When a trader is looking for a limited rise in a stock price, a bull call spread can be a superior alternative that solves the problems of the long call.

Dan Passarelli of MarketTaker.com[4] writes the Market Taker Edge options newsletter. Dan has more than 17 years’ experience in the options industry as a market maker, Options Institute instructor and author of “Trading Option Greeks.”

Source URL: https://investorplace.com/2011/02/buying-calls-3-problems-1-solution/

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