If done properly you don’t need a huge win ratio to make a lot of money investing in Call options. In addition, contrary to popular belief, investing in options does not have to be all that risky. However, a person does need to be careful to make sure the options have time to work for them and not against them.
Time Decay …
The first thing every options call buyer needs to understand is that time decay can have a huge impact on the ultimate return or loss on an option. Look at the example of time decay below:
Here we see that an option can lose up to 70% of it’s value in the last 30 to 45 days prior to expiration – and all options have expiration dates. Now if I am the one selling the option to an option buyer, I likely will be happy with a short time before expiration. The shorter the time the more likely the option will expire worthless to the buyer and I will be able to keep the premium the buyer paid me for the option, without having to deliver the underlying stock to the buyer of the option.
However, this article is about buying the options. In the case of buying you want to extend the time to expiration to give the underlying stock a chance to go up (in the case of a call option) or down (in the case of a put option) … which will in turn move the stock option premium that you paid (and will eventually sell) higher.
Be advised, however, that the longer out in time you go … the more you will have to pay in premium. Look at Microsoft, as an example:
Time Cost Example
- At time of this writing Microsoft Stock (MSFT) was trading at $112.33. If we wanted to purchase 1 contract with a strike price of say $115 this is what the premiums could run over the next several monthly expiration dates:
- March 15, 2019 – 1 contract at $115 would cost $0.73 per share or $73.00
- April 18, 2019 – 1 contract at $115 would cost $2.15 per share or $215.00
- May 17, 2019 – 1 contract at $115 would cost $3.50 per share or $350.00
- June 21, 2019 – 1 contract at $115 would cost $4.20 per share or $420.00
- July 19, 2019 – 1 contract at $115 would cost $5.00 per share or $500.00
- October 18, 2019 – 1 contract at $115 would cost $7.05 per share or $705.00
- January 17, 2020 – 1 contract at $115 would cost $8.80 per share or $880.00
- June 19, 2020 – 1 contract at $115 would cost $11.45 per share or $1,145.00
- I will not go any further than this … but you get the point. The more time before expiration … the more the option will cost.
The reason most people lose money in options transactions is because they are spending (in this case) between $73 and $215 and expecting to “Hit a Home Run” and all they get is a strike … and after three strikes … most of them are out.
But, the way I buy options … I don’t need 9 out of 10, 8 out of 10 or even 6 out of 10 to make money for me to profit. I can profit with only 5 out of 10 being profitable — or even less in some instances. I’m looking for base hits, doubles and a few triples … occasionally I will hit a home run even on these longer term options … and gladly accept them.
A look at Real Time Examples …
To understand what I am going to show here … first study and understand the chart below:
It does not take a rocket scientist to figure out that this stock has been trending up year to date. As a matter of fact since the 2nd of January the stock has increased from $101.37 to the $112.12 shown in this chart. That is an increase of about $10.75 or about 10.60%. Not too bad.
Now let’s look at the next chart …
This chart shows the price action of the June 19, 2020 MSFT Option with a strike price of $115.00. Remember until the stock gets to the price of $115 the option is considered Out of The Money (OTM). Again, it does not take a rocket scientist to see that the option price has actually been trending higher since the first of the year; just like the stock price has.
In this case it has gone from $8.90 per share (had you purchased at the high price on 01/02/2019) to a price of $11.20 as seen on this chart. Therefore there has been an increase of $2.30 per share or 25.84% … now that is a whole lot better than a return of 10.60% that the stock showed. Naturally, if you spent time at the computer watching the tick by tick movements you could have gotten better buy prices on January 3rd, 14th, 29, and February 1 (and other times in between these) … but that is hard work, and I don’t like hard work.
Another beautiful part on this particular option is that you have from today forward (not to mention from January 2nd forward) 478 more days before the option expires … and probably do not need to take a serious look at getting out of the option based on the time decay chart (Figure 2) shown above for another 433 days or so (I generally look to exit about 45 days before expiration if the option has been good for me).
This option currently carries a THETA (a greek term that measures the time decay) of -0.0130. This means if the stock does not move the option could lose about 1.3 cents per day in value. Currently the other Greek I pay attention too, the DELTA is 0.5234. This tells us two basic things:
- The price of the option should move up or down by about 52 cents for each dollar the stock moves up or down, and
- There is about a 52% chance that the stock will be at a price of $115 or more when expiration date arrives – so the option could expire in the money.
Now if the option expires in the money and I have not closed it out … I will be required to purchase the stock at a price of $115.00 per share. Considering that I paid about $8.90 per share on the option … I would not even break-even on buying and selling the stock unless the price was at least $123.90 ($115 strike price + $8.90 premium paid). So, this is why most options are sold before expiration.
While an option buyer has the right to purchase the stock at a set price before expiration of the option … if he has not gotten out of the option and the option expires in the money … the Options Clearing Corporation (OCC) may randomly assign the stock to his account, meaning (in this case) he would exchange his option and $11,500 for 100 shares of Microsoft Stock. Again, based on the price paid in options premiums … this would only be beneficial if the stock was at $123.90 or more.
Now let’s look at the final chart … the chart of the one who purchases an option with a much closer expiration date…
Now the first thing you notice here … even though the stock price is increasing and the option price for the longer term option is increasing … this shorter term option has a price action that is declining in value.
The price of the option has gone from a beginning price on 01/02/2019 of $1.27 to a price of $0.63 today. So while the stock has actually gone up 10% in value and the longer term option – that would have cost more than this option – has gone up 25% in value … this option would have lost the investor about 49% to date. I can’t tell you the number of times I’ve heard from people saying, “I just don’t understand. The stock price is rising, how can the option price be falling.” Now – if they are reading this they should understand it.
Now it is true that the investor could have gotten lucky (since none of us have a “crystal ball”) and purchased the option on February 20th for a price of $0.10 per share and turned around and sold it for a price of $0.63 per share today. That would have been an increase of 530% — the Home Run he was looking for. But, the chances of that happening consistently are very very slim. You would just about need a computer to be doing all the trading for you and those “robots” costs hundreds of thousands of dollars.
Currently this option has a DELTA of 0.2496 (half the longer term option) and a THETA of -0.0411 (almost 4 times the longer term option).
So Why Do I Love Call Options?
Because, you can invest less money and end up making greater returns due to the leverage that options afford you. In addition, when you invest in options you actually know up front what your maximum loss can be … the amount invested. That is not true with some other forms of investments.
However, when looking to invest in options I recommend that you research the stock first … not the options. In other words … if you see a stock you would not own in your portfolio … don’t even consider owning the option.
My Portfolio – A real life example:
Most writers will not show you their portfolio but are more than happy to show you portfolios that they have put together based on particular hypotheticals. Or, if they do show their portfolio they make sure to show only the gains or large gains and minor losses. What you are going to see below is my actual options portfolio that I made investments into between October 2018 and January 2019.
You will see some nice gains … some mediocre gains … some small losses and some relatively large losses. Keep in mind as you view this … for the present time all gains and losses are “unrealized” since nothing in the portfolio has been sold yet.
Let me explain the goal behind doing this portfolio before I actually show you the portfolio.
All investments should be made with an end goal in mind …
I decided after my motorcycle trip to Big Bend last September that I would like to purchase a new Indian Motorcycle (either a cruiser or a touring bike) in the next one year. When I purchase the motorcycle I will be selling or trading in my Harley. The cost of the motorcycle, the way I want it, will be between $25,000 and $30,000 – and being retired I did not want to use any of my retirement capital and certainly did not want to even consider financing it (even at 0%) since I am living on a fixed income. In other words … I did not want to use my money or my income to purchase this motorcycle. However, I am willing to use gains from some of my money to do this.
If you have known me for awhile you know that two years ago when I decided to purchase my new truck … I decided to do it the same way. Not to finance it or use any of the money I’d already accumulated for other goals and needs, for it. All money for the truck had to come from investment gains. I was able to make these gains in less than a year to buy that $45,000 truck. If I could do that in 2016-2017 … Then I thought it should be possible to do in 2018-2019 for the Motorcycle.
Here’s my portfolio as of about 12:36 PM Central Time today …
Since October I’ve been able to invest $39,477.58 and grow it to $68,583.00 giving me unrealized gains so far of about $29,105.42 (73.73% return on investment) in a little more than 3.5 months. Boy, I remember when I worked my tail off and did not make that much in a year.
Do I have losses … YES! 8 of 17 trades are currently at a loss. Some of those at a loss now was at a gain a month ago and some that were at a loss a month ago are at gains now. That is the nature of investing. You are never going to hit a 100% win ratio consistently. If your gains are larger than your losses, though, you will be okay. If I would have lost on all of these accept Boeing … I’d probably still be up over all in value … and last year around Thanksgiving my first purchase of Boeing was down 37% and look at it now … just two months later.
You can see here that on 11/02/2018 I purchase 1 contract on the AAPL 01/17/2020 $210 Call options at a cost of $25.85 per share. By 11/13/2018 the price of AAPL had fallen and the option dropped to $18.75 per share. I purchase 2 more of the same contracts (that’s called doubling down). Then on 11/26/2018 the price of the stock continued to decline and the options were down to $9.30 per share. I purchased another 3 contracts. Now if you look at my cost per share on AAPL it is at $15.2084 and not $25.85, or $18.75. The current price per share of the options stands at only $4.42 so the overall I am still down about $7,470 (or 71%). However, there is still a lot of time remaining before the options expire – 324 days to be exact – though I will be looking to get out (if in the money) in about 280 to 290 days from now.
Since the first of this year AAPL has grown from $142.19 to a current value as of this writing at $173.15 – so there is still some potential. The only thing I regret thus far is that I did not purchase more contracts back on January 2, 2019 when they were on sale for around $2.00 per share. On those I would have been up over 100%. I would have also dropped my over all cost by a great deal more. The jury is still out on this one … don’t be surprised if I don’t turn around and purchase some more of these.
As for BA my first two contracts was bought on 10/30/2018 (actually the second was a mistake … but I’m sure glad I held it and did not call for a market correction) for about $39.22 average. As I said earlier the price fell by Thanksgiving and I came back on 11/26/2018 and did another two contracts at a cost of $24.60 per share … bringing my average cost per share down to $31.91. The rest is history … this stock has skyrocketed from a low of $293.16 on December 24th to a value as of this writing at $439.96. With the strike price of the option being $350 this group of options are now “in the money” by $89.96 per share. Based on the chart in Figure 6 I am sitting on a gain on this one in the amount of $28,536.97 or 223.59%.
I had a friend call me today and ask how high could BA go … I simply said … “Higher than to the moon and back.” We need to jump out at the moon … but I don’t know exactly where or when that will be.
My next decision …
Do I sell BA to purchase the motorcycle … or do I sell some of the rest to purchase the motorcycle and hold BA for potentially more gains. I have about a month to go so I will keep you informed.
In the meantime … I’ll keep making waves … and I hope this was meaningful for you!
Have a great day,
Jerry Nix, FreeWaveMaker, LLC
This information is not recommendations for you to purchase or sell any investments outlined in this article. The information is being shared for educational purposes only. I recommend that you seek the advice of a licensed and competent financial advisor before taking actions on your portfolio if you see a need to after reading this article.
The author of this article is long on the following investments outlined herein: the investments shown in the article in Figure 6.