Options Trading: Putting the Odds Back in Your Favour

Options Trading: Putting the Odds Back in Your Favour

When investors get started in options, the first thing they’ll usually learn about is call options. Perhaps that has a lot to do with how most books and learning material on the subject is structured.

Because the bulk of investors come into the market from the ‘buy side’ — that is, they’re a natural buyer of shares and not a short-seller — a call option makes the most sense to someone just starting out.

If you’re not familiar with call options, the buyer pays a premium to the option writer (seller) to lock in a purchase price in the future. In effect, the call option buyer is buying time to see how the trade plays out.

If the share price jumps, they’ve already locked in their purchase price at the option’s strike price. But if the share price flounders, the most they lose is the premium they paid — typically only a fraction of the value of the underlying contract.

On the face of it, buying call options seems like a pretty neat idea. It’s a way to gain exposure to the upside, while limiting the downside. ‘Limited risk and unlimited reward’ is often the refrain that accompanies the strategy.

But if you’ve bought call options before, you’ll know that it’s not quite as simple as it looks. If it was as easy as that, surely everyone would just buy call options instead of shares.

Great idea, but doesn’t always work

When you buy a call option, you have a number of hurdles to overcome before you make any money.

The first of these is the option’s strike price. This is the price at which the shares change hands if the buyer exercises the option. If the share price doesn’t at least equal the call option’s strike price, there’s no reason to exercise the option.

That’s because there’s no point exercising a call option if you can buy the shares cheaper on the market. The only time a call option buyer might do so is to collect an upcoming dividend.

But it’s not just a case of the share price hitting the strike price. The option buyer also has to recoup the cost of the premium they paid. The share price has to surpass both the strike price, plus the cost of the option, before the trade is profitable. This is called the ‘breakeven’.

Of course, all this is happening with the ever-present ticking of time decay. As all options have a finite lifespan, the share price has to reach the breakeven before the option expires.

However, because options are such a flexible tool, there is something else a call option buyer can do to increase their chance of success.

Putting the odds back in your favour

Let’s say that a share is trading at $10. And in this example, you can buy a $10.50 call option for 50 cents. You can work out the breakeven straight away. It’s the strike price ($10.50), plus the cost of the premium (50 cents), which equates to $11.

You can see the tradeoff between buying the shares or options. If you buy the shares, your breakeven is your purchase price — $10 in this example. However, you have to fork out for the entire value of your shares right now.

If you go with the call options instead, you only need to pay a premium now. However, the share price has to reach $11 before you make a profit. Plus, you need the share price to reach this target before the option expires.

To help overcome this hurdle, option traders use something called a ‘spread’. It involves buying a call option (as per the example above), but adds another leg.

The second leg is to write (sell) a call option with a higher strike price than the one you bought. To marry the two trades together, you need to use the same expiry month for both options.

To continue with the above example, let’s say you bought the $10.50 call options for 50 cents. That’s leg number one.

Leg number two is writing a call option with a higher strike price. In this example, let’s say we can write an $11.50 option and receive 20 cents. By selling the higher strike option (at $11.50) for 20 cents, it reduces the costs from buying the lower strike call option ($10.50 strike price).

By doing this spread trade, the total outlay for premium reduces to 30 cents. That is, the 50 cents you paid for leg number one, less the premium (20 cents) you received for leg number two.

Don’t let the jargon get in your way

Options traders call this strategy a ‘bull call spread’. But don’t let the jargon confuse you — just break it down into its individual components.

‘Bull’ because you believe the stock is going to rise. ‘Call’ because you’re using call options. And ‘spread’ because the strategy involves both the buying and writing (selling) of options (with the same expiry date).

By doing a bull call spread, you are lowering your breakeven. In the example above, the breakeven drops to $10.80 — 20 cents less than only buying the $10.50 call option by itself.

However, this strategy comes with a limitation too. That is, it limits the amount of profit you can make. If the share price rallies strongly above both strike prices, you pick up the shares by exercising the option at $10.50.

However, the person we sold the higher strike call option to will also exercise their option. Meaning that if the share price in this example rose to $15, we’d take delivery of the shares at $10.50. However, we’d have to hand over the shares at $11.50 (if the option buyer exercises the option we wrote).

There’s always a trade-off between any strategies. By buying just the call option, you could potentially receive a higher return. But the share price has to run further — is it realistic before the option expires?

A spread trade lowers your breakeven, and therefore improves your chances of success. But you’re also giving up potential profits if the share price rallies strongly.

Matt Hibbard,
For Markets & Money

Matt Hibbard

Matt Hibbard

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years.

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