Ian, are you now into options trading?
At this stage, not yet. This is because my knowledge on it is rather basic. I know that many have an interest in it as they see options as a trading vehicle to earn income. As for myself, I wasn’t in it as I prefer to buy, hold and keep stocks as a value investor.
But lately, I like to revisit the basics of options to deepen my knowledge in this area.
This is because, perhaps, options can be considered as a tool in value investing. Here, I’ll like to document some notes and reflections from my studies in this area in a series of articles. For this write-up, I’ll cover what “call options” are and how they could work for investors.
A Problem Faced by Value Investors
Let’s assume I like to invest in A Co, a fundamentally solid stock listed in the U.S.
I value A Co and would like to keep accumulating its shares, as long as it is below $300 a share, in the next 12 months.
In the first month, A Co trades at $290 a share. Since it is below $300, I invest.
In the second month, A Co trades at $280 a share. Since it is below $300, I invest more.
But, in the third month, A Co trades at $320 a share. I decided to not buy as it is above $300.
In the fourth month, A Co trades at $340 a share. I won’t buy it as it is above $300.
For the remaining eight months, A Co trades above $350 a share. I won’t buy it either.
In the end, I invested and built a small position in A Co. Sure, there are capital gains, but are not much as the weightage of A Co in my portfolio remains relatively small.
Let’s do some maths.
Assuming that I would buy just 100 shares for each transaction.
I would have invested $57,000 to buy 200 shares of A Co in that 12-month period. Each share is costing me on average $285 a share.
One year later, A Co is trading at $380 a share. Thus, my 20 shares are worth $76,000. This will work to be $19,000 in capital gain.
How Call Options Could Help Investors?
Basically, I can buy call options, which give me the right to buy A Co’s shares at specified prices (strike prices) at any time before they mature or expire.
For instance, in the first month, I can buy call options that allow me to buy A Co’s shares for “my predetermined maximum price” of $300 a share at any time before they mature in a year (twelve months). I’ll pay a premium for these call options to a seller.
Upon buying these call options:
In the first month, A Co trades at $290 a share. Since it is below $300, I invest.
In the second month, A Co trades at $280 a share. Since it is below $300, I invest more.
But, in the third month, A Co trades at $320 a share. I can exercise the option and buy shares of A Co at $300 a share.
In the fourth month, A Co trades at $340 per share. I can exercise the option and accumulate its shares at $300 a share.
For the remaining eight months, A Co trades above $350 a share. If I have any more options left in my account, I would exercise them and buy its shares at $300 a share.
My final cost for all shares bought via options would be “$300 + Premium for these options”. But, they are definitely way better than buying shares in Month 3-12 at current prices. In this manner, I could build a larger position of A Co in my portfolio.
Let’s assume that I had bought 3 call options that allow me to buy 100 shares at $300 a share at any time within the next 12 months each.
So, I would have invested $147,000 + Premiums to buy 500 shares in A Co.
One year later, these shares are worth $190,000.
My final capital gain would be $43,000 – premiums, which is way bigger than $19,000.
Difference between Traders and Investors
Typically, option traders are interested to profit from the price difference.
Let’s say a trader buys the same option contract that allows him to buy A Co at $300 a share. To him, at a certain price (let’s say $340 in Month 4), he could exercise his option by purchasing his shares at $300 and immediately, selling them off for $340 a share. Thus, he could profit from the price difference instantly. In that case, he calculates his trading profit as follows:
Trading Returns = (Price Difference / Premium) / Premium x 100%
Let’s say the premium is $8 per share (I’m making this up). From A Co., the return is 4X from his capital made.
Trading Returns
= (Price Difference / Premium) / Premium x 100%
= ($40 – $8) / $8 x 100%
= 400%
As investors, since the focus is on accumulating its shares, the above calculation isn’t relevant.
Of course, by keeping shares (not selling them), I’ll be subjected to the ups and downs of prices. A Co can increase further or decline in the future. So, if it goes up to $400 a share, great! I could see myself having much larger capital gains. Otherwise, if it falls back to $300 a share, my gains would be wiped out.
What if A Co’s Stock Price Falls?
What if an option trader buys the above call options and A Co’s shares never rise above $300 in the next twelve months?
Let’s say, in the next twelve months, A Co’s shares are trading as shown below.
Well, the option trader would be disappointed. All the premiums that he paid would be worthless. His capital would be wiped out.
But, if I’m a value investor, it is a different story. Since my objective is to accumulate, I would buy A Co in the open market as its prices stay below $300. The premiums would expire but I’m not a trader who calculates returns based on “premiums”. So, I’m okay.
Conclusion:
The above offers a simple illustration of what a call option is.
I would probably read up what a put option is and write an article on it. Stay tuned.
