Foundations of Trading: Options [Part 5]

Welcome back to our following Foundations of Trading Options blog. In today’s blog, we will cover a few thoughts from Chris regarding his Long Calls Strategy presented in FoT Options Class 3. However, before we dive into today’s topic, if you need or wish to revisit any part of our current options journey, please click on the Foundations of Trading blog category on the right-hand side of the page, and that will instantly bring up all the blogs from our program for your review. Now, let’s get to it.

As a reminder, a call option gives you the right to buy a stock at a specific price. The monetary value of a call option increases as the value of the underlying stock increases, which means call options are bullish in nature. These options are valuable to short-sellers as they function as a type of price insurance. On the flip side, a put option gives you the right to sell a stock at a specific price. The monetary value of a put option increases as the value of the stock decreases, which means ​put options are bearish in nature. These options are valuable to long buyers as they function as a type of price insurance.

Let’s look at a long call example that Chris presented in class 3.

Let’s say you’re bullish on Micron Technology (MU). By buying the 80-strike call option, you reserve the right to buy MU for $80 a share. If MU goes to $84 or even higher, you still have the right to purchase shares for $80. If you think MU could get to $84 in the next few weeks, the real question becomes how much would you pay for the right to buy MU at $80?

We agree that being able to buy at $80 is worth at least $4 when MU is trading at $84, right? That’s because you could exercise your right to buy shares at $80 a share, then immediately turn around and sell them to the market at $84 a share, netting yourself an instant $4 profit. So if Micron Technology went all the way up to $90, how much would it be worth to have the right to buy at $80? The higher MU goes, the more valuable the right to buy at $80 becomes. Just like a stock, our call option can go up in value forever. However, is there a downside to this trade?

When you buy a stock, you can lose as much as you paid for that stock which in this case would be $80 per share. That’s true for options as well, but options cost a lot less. Right now, the 80-strike call option costs $2.54 a share. This means that the most you could lose on this stock is $2.54 a share, no matter what the stock does.

By buying a call option, we still get to participate in the infinite upside that comes with stocks, and at the same time, we limit our risk to only a fraction of what we could lose on the actual stock trade. Rather than paying $8,000 to buy 100 shares of Micron Technology, we can control the same shares by spending only $254 for a call option. If MU goes up, we enjoy unlimited upside for only a fraction of the financial risk.

If MU goes to $84 by expiration, the 80 strike calls that we paid $2.54 a share for will be worth $4 a share. That is a 57% return. If MU goes to $90 by expiration, the calls will be worth $10 a share which is a 293% return. However, if MU is at $81 at expiration, the calls will be worth only $1 a share or -60% return.

I​n Closing

In short, you would buy calls when you expect the stock to go up in price as a long call option structure is another way to express a bullish view of a stock. Finally, if you have any questions regarding the contents of this blog, please stop by to see our teachers and moderators in our Group Coaching sessions which happen every Thursday, and have Chris dive a little deeper into his example. For access, please contact Rebekah at info@tradesmartu.com for details on Group Coaching sessions. Thank you for reading, and we look forward to seeing you next week!