Active traders who want to participate in this market can use options to limit their risk to an adverse move. Today we investigate the simple Bullish Call option strategy of buying calls to participate in profits, when the underlying stock price rises.
The S&P/ASX 200 has sold-down sharply this week, led by the materials sector. The index is now searching for support around the key medium-term pivot level of 4180. This level has provided support over the past few months. Active traders who want to trade in this market and who are looking for a bounce in the materials sector, can buy calls for a limited risk entry into a specific stock.
There are a number of reasons why a long term investor may not want to jump into an outright stock position in this market environment, such as the risk of further falls and being exposed to price gapping overnight.
The Bull Call option strategy is a cheaper alternative to buying the stock. By buying the call option, you limit the cost of the exposure to the stock, while also limiting the risk in holding this position.
Buying Calls To Profit From Stock Price Rises
Call options are financial contracts between a buyer and a seller for the purchase of a particular stock (or whatever other underlying asset it is based on). The seller (or “writer”) is giving the buyer of the call options the right to buy the stock at a fixed price. The buyer (or “holder”) of the call options wants the underlying stock price to rise before the options contract expires.
The buyer of a call option expects the underlying stock to go up and is willing to pay a small price to speculate on such a move. Call options enable you to buy the underlying stock at a price fixed right now, no matter how high it rallies in the future for a small price relative to the price of the underlying stock, without first having to buy the underlying stock.
Call options are very flexible and provide a limited risk exposure to the underlying stock. They allow you to
profit from a rising underlying stock price, taking advantage of new trends or swings very quickly and can also be used to hedge away positional risks.
For the buyer of a call option the maximum risk is limited to the initial premium paid for the call option, while the maximum profit is unlimited.
Recent Trade – Newcrest Mining (NCM)
A recent trade that our clients took was to buy Newcrest Mining April $31.50 Call options, when Newcrest Mining was trading at $30.65. Newcrest Mining has sold-down sharply in the past fortnight (around 15%) and this call position was taken with the view that Newcrest Mining would trade back towards the upper end of the trading range (shown in the chart) below. Note another positive for this trade is that the $30.00 level has held as support all the way back to early 2010.
In this trade we entered when NCM was trading at $30.65, and the trade was established by Buying to Open NCM 3150 APR12 Call for 95c. The total cost is limited to the initial 95 cents premium paid.
Note if you were more bullish and expected NCM to surge near–term, you would have bought a further out of the money call to give you more leverage on the position.
FIGURE 1: Payoff diagram for the Bull Call on Newcrest at expiry
This trade can be analysed using the Derivative Profiler option in the Market Analyser software.
Risks and Profit Potential
The Bull Call profits when the stock price trades above the strike price. For the buyer of a call option the maximum risk is limited to the initial premium paid for the call option. The maximum profit is unlimited.
Profit Calculation of the NCM Bull call:
Maximum Return = Unlimited
Following up from the recent trade example:
Buy to open 10 NCM 3150 APR12 Call for 95c per contract.
Maximum Return = Unlimited
Maximum Risk = Net Debit = 95c, if NCM share price is < $31.50
Break Even = Strike Price + Net Debit = 31.50 + 0.95 = $32.45
In summary the bull call strategy offers a maximum upside profit which is unlimited, while the maximum risk is limited to the Net Debit Paid. These risk/rewards are shown in the Payoff diagram.
An interesting aside is to examine the payoff as the trade progresses, as shown in the diagram below. Note that the break even is reached sooner because of the time value left in the option.
FIGURE 2: Payoff diagram for the Bull Call on Newcrest at two days into the trade.
Note this Bull Call strategy can be used in order to gain an exposure to Newcrest, while limiting your outlay and risk to the premium paid.
The Trade
Options can be used to gain leveraged exposure with limited risk, while still participating in potential profits from a significant move by the underlying stock. Here we’ve explained the Bull Call strategy which can be used to allow you to participate in the rising stock price of the underlying stock, while limiting your loss to the premium paid.
In future articles we will talk about the High Yield Covered Call strategy and the Covered Call Stock Reversal strategy which is particularly relevant to this market.
Utilise the features in the Market Analyser software to plan your options trading strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk.
By Michael Hevern
MDS Trading Desk
Options Trading for All Types of Market Environments (Part 1): The Protective Put
Options Trading for All Types of Market Environments (Part 2): The Covered Call
Options Trading for All Types of Market Environments (Part 3): The Covered Call Collar
Options Trading for All Types of Market Environments (Part 4): The Stock Repair Strategy
Options Trading for All Types of Market Environments (Part 5): Limited Risk Short Selling Strategy
Options Trading for All Types of Market Environments (Part 7): Dividend Capture Covered Call Collar
Options Trading for All Types of Market Environments (Part 8): Hedging With a Bear Put Spread
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This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of MDS Financial Services Pty Limited ABN 28 088 190 283 AFSL No. 333298 (MDS), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by MDS Financial Services Pty Ltd, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
