Buying Naked Calls - Part Two
...continued from Part One
At-the-Money: Insurance In Both Directions
A call that has a strikeprice that is equal to the stock price is known as an at-the-moneycall. Naturally, for an at-the-money call, which is insuring any lossbelow the current stock price, we pay a higher time premium than wewould for the in-the-money call, which only insures against lossesbeyond a certain drop in the stock.
However, when you buy an at-the-money call, you are also buyinginsurance against the stock going up! This is because you canparticipate in all gains in the stock above the current stock price.After the fact, you will not have to say; "I wish I had bought thatstock"
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Look at (Graph 2). Here we show the P/L on the at-the-money $15 strikeAugust call at $1.35 on this same stock. The most you can lose is the$1.35 time premium you paid for this option (no deductible).Alternatively, on the upside you get to participate in profits abovethe current stock price (again no deductible).
Out-of-the-Money: Insurance Against Not Buying the Stock
You can also buy a call in which the strike price is higher than the stock price. This is known as an out-of-the-money call.
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Look at (Graph 3). In the example we have bought the $17.50 strikeAugust call on Integrated Device at $0.45. At expiration, you only makea profit if the stock goes above this $17.50 strike price. Here thedifference between $17.50 and $15.00 is your deductible.
On a certainlevel, an out-of-the-money call can be highly speculative, since thereis a good chance that it can expire worthless. However, if you want tobe mainly invested in cash and bonds, but want some insurance againstmissing out if stocks rise, then out-of-the-money calls can be the wayto go.
Your Best Call?
Which call is best - in-the-money, at-the-money or out-of -the-money?That depends on you’re your risk/reward appetite. With an in-the-moneycall, the stock doesn’t have to rise by very much for you to startmaking a profit, but you are taking a position that is a bit more likeowning the stock with some of the same downside.
With an at-the-moneycall, you have no downside exposure - and you are also insured againstmissing out if the stock rises. However, you pay the highest timepremium for this "two-way" coverage. With an out-of-the-money call, youcan get a very handsome return if the stock makes a big move, but youalso run the very real risk of the option expiring worthless.
Which of these options do we recommend? In fact, our model has no biasfor in-, at- or out-of the-money calls. If the premiums areattractively priced and the underlying stock is highly ranked, then the calls are likely to highly ranked as well.
What weoften find is that a lot of the bargains are in the less glamorousin-the-money calls, while a lot of the less attractively priced calls(i.e. those that are overpriced) - are among the more glamorous highlyleveraged out-of the-money calls.
Often, you have to look at the options that are being ignored by the market to find the best bargains.
Posted By: The Value Line Daily Options Survey
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About Lawrence D. Cavanagh
Lawrence D. Cavanagh is Editor (and Senior Analyst) of The Value Line Daily Options Survey. The Value Line Daily Options Survey offers evaluations and rankings on virtually the entire universe of regularly listed equity and ETF options, using the Value Line common stock ranks and proprietary volatility forecasting methodology. Before joining Value Line in 1991, Mr. Cavanagh was an options strategist for Capital Market Technologies (subsidiary of Elders Finance), helping design long-term synthetic foreign currency and gold option hedges. Before that, he was Director of Foreign Currency Options for the Chicago Board Options Exchange. Other work experience includes Dean Witter Reynolds (VP, Senior Currency Analyst), European American Bank (Director of Currency Forecasting) and the Federal Reserve Bank of New York (Assistant Economist).
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