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4 Alternatives to Buying Call Options


An investor who wants to go long a security can buy that security, or buy a call option. A call option gives you the right to buy the stock at certain price. The big advantage of call options is the fact that it requires much less capital than buying the stock. For example, you will need about $77,000 to buy 100 shares of GOOG).

At the same time, buying one At The Money (ATM) call option will cost you only ~$2,200.

 

Pros and Cons of buying a call

 

The main advantage of buying a call option is leverage. You control the same amount of the stock with much less capital. However, there are few significant disadvantages. When you buy a call, you have to be right about the direction of the move, the size of the move and the timing. You can be right about the direction and the size, but if the stock doesn't move quickly enough, your options might expire worthless. You can be right about the timing, but if the stock doesn't move far enough, the trade will still lose money.

 

For example, if you buy the GOOG ATM options for $22, the stock has to move $22 by October expiration in order for the trade just to break even.

 

Alternative #1: Selling naked put

 

One of the first alternatives to buying call options is selling a naked put.

 

When selling the put, you are attempting to achieve one of two goals:

  1. Profit. You are bullish on the stock and expect the put option to lose value and expire worthless as time passes. If the latter happens, the option premium becomes the profit.
  2. Buy stock at a discount. If the put option is in the money when expiration arrives, you will be assigned an exercise notice and be obligated to buy the stock you want to own at a discount to today’s price.

The maximum profit is the premium received for the put. The trade makes a profit in each one of the following three cases:

  1. The stock stays unchanged.
  2. The stock increases in value.
  3. The stock decreases in value but stays above the strike of the put.

The main advantage of the naked put selling is increased margin of safety. You can be wrong and still make money. The main disadvantage is the fact that the profits are limited to the price of the put, no matter how much the stock increases in value.

 

Alternative #2: Selling bull put credit spread

 

While naked put is less risky than buying the stock (in worst case scenario, you will be forced to buy the stock at price which is lower than today's price), it still exposes you to a big loss in case of significant decrease in the stock value. The second of the alternatives to buying call options states that in order to limit the loss, you can sell a put and simultaneously buy a put at lower strike, creating a put credit spread.

 

Credit spread makes money in the same cases as the naked put (the stock needs to stay above the short strike), but the loss is limited to the difference between the strikes. It also requires less margin than the naked put in most cases, so return on margin might be higher than naked put.

 

A put credit spread is considered by many the best of all worlds. It has a limited risk and gives you a nice cushion in case you are wrong. While the profit is limited to the premium you get, it can still provide very reasonable return on risk. For example, if you sell a $10 wide credit spread and get a $2 credit, your risk is $8 (the width of the spread less the credit received). If the spread expires worthless, your gain is $2/$8 = 25%. Not too bad.

 

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Alternative #3: Buying bull call debit spread

 

A bull call spread is used when an investor expects a moderate rise in the price of the underlying asset.

 

Bull call spreads can be implemented by buying a call option while simultaneously writing a higher striking call option of the same underlying security and the same expiration month.

 

By shorting the out-of-the-money call, the options trader reduces the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the underlying asset price skyrockets.

 

Since a bull call spread involves writing call options that have a higher strike price than that of the long call options, the trade typically requires a debit, or initial cash outlay. The maximum profit in this strategy is the difference between the strike prices of the long and short options less the net cost of options. The maximum loss is only limited to the net premium paid for the options.
 

The main advantage of Bull call spreads is less capital than buying a single call. In some cases (usually when the long call is In The Money) the trade can be even theta positive.

 

Alternative #4: Buying bull calendar spread

 

A calendar spread involves buying long term calls and simultaneously writing an equal number of near-month calls using the same strike price. The trade can be done with puts as well.

 

The maximum gain is realized if the stock trades at the strike at expiration. In this case the short calls expire worthless but the long calls still have value.

 

If you are bullish about the stock, you can select the strike price above the current stock price, based on your estimate where the stock will be trading at expiration. For example, if the stock currently trades at $100, and you believe it will be at $110 a month from now, you can buy a $110 calendar spread by buying longer term $110 call and selling short term $110 call. If the stock stays below $110 by expiration of the short call, you will keep the full premium received for the short call, offsetting the cost of the long call.

 

The disadvantage of this strategy is that if the stock moves too far from the strike (in either direction), the trade will lose money.

 

Conclusion

 

There are some alternative strategies to buying a long call. No strategy will work in all market conditions. You should select the appropriate strategy based on numerous factors: the market conditions, the stock behavior, etc. For example, in a strong bull market, buying a call might be the best choice. In neutral to slightly bullish market conditions, more conservative strategies might provide a better risk/reward. 

 

Options are a wasting asset. The biggest advantage of the alternatives described above is the fact that they are usually theta positive, so they benefit from the time decay. In comparison, buying a call is a theta negative strategy, and is considered a more aggressive trade. Of course the other side of the coin is the fact that you limit your gains with those strategies, while buying a call has unlimited profit potential. Options trading is about risk/reward and trade-offs.

 

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