Profits and losses
The maximum loss the investor can suffer is the premium paid for the option, which will occur if the share price at expiry is below the strike price. The investor breaks even if at expiry the share price is equal to the strike price of the option plus the premium paid. As the share price rises beyond this point, the potential profits of the bought call are unlimited.
- Time decay: time decay works against the buyer of the call. If the expected share price rise does not take place soon after entering the position, time decay will start to erode the value of the option.
- Strike price: the investor will usually have a choice of strike prices, and must balance the cost of the option against the rise in share price required for the strategy to be successful. The out-of-the money option will be the cheapest, but also requires the largest rise in share price. Many investors regard the at-the-money option as offering the best balance of risk and reward.
- Expiry month: a longer-term option allows more time for a rise in the share price to take place, but will be more expensive than a shorter-term option. The investor needs to form a view of the time frame over which the share price movement is expected to take place.
If the share price rise takes place as expected, the call option taker must decide whether to close out at a profit, or maintain the position in the hope of a further increase in price. The longer the option position is left open, the greater the effect of time decay.
If the share price does not rise as expected, it is often advisable to close out the position in order to recover some time value from the position.
If at expiry the option is in-the-money, the investor must choose whether to sell the option or exercise it. The choice will be determined by whether the investor wants to own the underlying shares.
Points to remember
- Only buy calls when you expect the share price to rise, and volatility to increase.
- Be realistic in selecting a strike price - the out-of-the-money option will be cheapest, but also requires a large move in the share price for the strategy to be profitable.
- If the expected share price rise does not eventuate, be prepared to take a small loss by exiting the position, rather than holding on until expiry and possibly watching your option expire worthless.