For many people you might be interested in going with a call option because you think the stock is gonna go higher So you want to go ahead and buy the call option.
When you buy a call option, you have the right to purchase that stock at some future date and time at a certain price that you determine.
That is known as the strike price.
Can you get out of it early? Absolutely.
Do you have to buy the stock shares and then sell them later? No.
Why not? Because the value of the call option, this contract that you get will become worth more.
You don’t have to buy the shares and then resell them later. You can just sell the contract because it’s now worth more money to somebody else. I don’t think buying a single option contract is the smartest approach.
I’ll share with you that as we go through kind of this trade example. Let’s say I am interested in Facebook here.
So if I want to buy this stock and I’m interested in 100 shares. You’re gonna be paying about 23,000 dollars at this point in time. So 23,000 dollars is quite a lot. So what many people are interested in doing is buying a single call option contract.
Now you could look at the calls right here. Here I have my days till expiration.
Here is the date.
So if I go July right now that would be 57 days out. As I scroll down, you’ll see in the middle, have strikes. So if I think the stock will go to 270, I can get a call contract for the price of 2.29 dollars.
If I think it’ll go to 240, I’ll pay 10.30 dollars. Why do I pay more for the 240 versus the 270? It’s because 240 is a lot closer to the current price. That means it has a higher chance of success. So to have a higher chance of success, you got to pay up because current price is 234.
Remember that a single option contract is controlling 100 shares. That means if you’re buying this one, you’re actually paying not just 10.30 but you’re actually paying 1,030 dollars.
So here I am on Facebook, I have one single call contract.
You’ll see that my profit and loss, which is the green line, is gonna show me negative 1,035 dollars. Why is that? Well it’s because, remember we said it’s controlling 100 shares, 100 times 10.35.
That means 1,035 dollars will be taken out of my account as margin, as kind of collateral. Holding it until we see what happens until the stock, either moves up or moves down. I could go ahead and place the order and you’ll notice I have two lines here.
- green line – expiration
- white line – today
So today if it moves up, let’s say to 250, you could go ahead and make 855 dollars.
How is that possible?
What it’s doing here is it’s taking the stock movement along with all these other values. Giving you kind of an estimate of what your profit and loss will be at that time. Now the issue with a single call contract is you have time value that works against you because you’re buying something that expires, right?
You’ve bought it 30, 45 or 60 days out in the future. When that happens, you lose time value just like on an insurance premium contract.
In our case this is known as the theta and we are losing 10.90 dollars every day.
Because of the bid-ask spread I’m down about 12 dollars.
So if I move it to the next day forward, I will lose about 10 dollars each day. You can see this process and why a lot of people who buy single call and put options actually lose. They lose because they’re betting on directional movements and not really making money from time decay.
So you’re paying for the option or the choice of getting this stock at a further higher price.
The cool thing about this is you can leverage your position up if you don’t have a lot of money.
For example, rather than paying 23,000 dollars to have the stock, you could create a replica of this still getting some upside movement but you pay a lot less.
You pay a thousand dollars instead of 23,000 dollars.
How does this work? Well it mimics you based on your Delta. This is in a way a 46 share stock alternative because your Delta is 46.
When you have a delta of 46, it means for every $1 move you make 46 dollars. If I move it up a dollar, we had about 40 dollars.
Let’s say we go up to $2, add 46 to 40, you’ll get your $86.
So that’s how it works. You basically have now 46 shares here with this option contract. If you go further duration, let’s say $260, well you pay less.
This one is a $405 but you have less stock shares. You have 23 stock shares — 23 Delta.
So if you mimic this in a stock share world, you make $23 for every dollar move the stock moves up. Let me show you how this works on the stock world, let’s say I buy 23 shares.
This is a linear approach. Whereas an option approach, you get a little more curvature because the time decay and Vega and many other factors. But here I have a 23 Delta. My profit and loss as at 0.
If I go ahead and move this up a dollar, I will make 23 dollars.
If you look at the option contract here.
Well it’s the same way, I’ve got 23 as an alternative but I only pay $400 for this option contract. Whereas 23 shares of Facebook, you can see it’s gonna charge me about 5,400 dollars.
So paying $400 versus $5,400, that’s the big difference. The downside to this when you’re dealing with an option contract is you pay for that with the time decay. We have a negative theta here, a negative 8, which means every day I lose about $8.
So you can see now I’m down to 18.
As time goes by, that white line starts getting closer to that green line.
Which means if you’re buying a contract at around 260, you have to move fast enough to offset the time loss that you’re gonna incur in this contract.
Now this is why I don’t recommend single option contracts for most people.
I mean most people start out this way and you’re probably brand new or you’re just starting out this way. But it’s not the smartest approach. Normally what we do is things like spreads.
This spread examples been up for about a week or two, the time decay here on the theta is positive instead of negative. What we’re doing is we’re selling a spread. I don’t care if that stock goes between you know about 116 to 230, you’re still gonna be making money.
If it expires, you make about 495 dollars on 1,505 capital. So that’s the way that this trade is working and functioning.