Monday, August 10, 2009

Using Call Options

In Preparing to put Funds Back into Stocks, one strategy I am using is to buy call options on certain stocks that I think will advance a lot. Thus, for the small cost of the option price, I can have significant upside gains, while limiting the downside to only the option price.

For reference, buying a call gives the owner the right, but not the obligation, to buy a stock at a certain price before the expiration date. Selling (writing) a call obligates the writer of the call to sell a stock at a certain price up to the expiration date. For a more detailed definition see this Wikipedia article on call options.

For example, many market strategists believe that technology companies, e.g. Cisco (CSCO), Microsoft (MSFT) and Intel (INTC), will lead the economy out of this recession. Therefore, own these stocks would be profitable as the economy recovers. However, I think there is a reasonable opportunity for another dip in the economy before a longer term recovery. In such an instance, investment in these stocks might result in large short term losses.

To minimize short term losses, and participate in a short term rally, I am choosing to buy call options on selected stocks. For example, I recently purchased Intel options that expire on Jan 2010 (strike 22.50) and Jan 2011 (strike 30) for a price of $43 and $31, respectively, per contract. If Intel rises above $22.50 before January 15, 2010 or $30 before January 21, 2011, I will make at least $100 per contract for every dollar above the strike price. However, if Intel closes below the strike price after the expiration date, then I will only lose the $43 or $31 per contract.

Since Intel is current around $18.50, the stock can rise up to $4 and I would still lose my option payment in January, 2010. However, if Intel falls to $4 per share, I will only lose my option payment of $43 per contract (or $.043 per share). Thus, for me a call option is low risk way for us to participate in a short term advance in the market, without large potential loss if the market goes down.

Disclosure: At time of publication, we own Intel calls in our trading account, and shares of Intel, Cisco and Microsoft in our managed accounts.

For more on Strategies and Plans, check back every Monday for a new segment.

This is not financial or investing advice. Please consult a professional advisor.

Copyright © 2009 Achievement Catalyst, LLC


pfstock said...

First of all, I want to wish you good luck with this strategy since I also own shares of Intel. I was previously approved for options trading in my brokerage accounts, but I haven't actually executed any options trades. The reasons may not be what you would guess...

I'm concerned about properly recording option trades on my tax return. Could you shed some light on this topic? I also noticed that you previously wrote about your tax return weighing more than a pound, and that you recently needed to file an extension for your tax return. Is this related to your trading activity?

Super Saver said...


Thanks for your comment and good luck to you also on Intel.

In answer to your question, I treat option trades the same as stock trades. Buying options is like buying a stock. The purchase happens first, followed by a sale (or expiration). Writing options is like shorting a stock, in which the sale (or short) happens first followed by a buy (to close) or expiration. In both cases, sale price minus buy price equals the profit or loss, irrespective of the order in which they occurred. The main difference from stock trades is that sometimes an option will expire worthless, making either the final sale or final buy price equal to zero. As with stock transactions, the information is recorded on Schedule D. Hopefully, I've answered your question. If not, let me know.

While our tax return weight was due to trading activity, it wasn't my personal trading. One of our taxable managed accounts had very high trading activity. Instead of filling out Schedule D with hundreds of trades, I chose the option of sending in the gain/loss summary from the brokerage, which the IRS accepts as a alternative to providing details.

However, filing for an extension is not related to trading activity. I just like the extra time to make sure I do thorough job in preparing our tax return.