Buying Naked Calls
Should you buy calls? Many people say you should not, but we beg to differ. In the early days of option trading (1970s and 1980s), calls and puts were often prohibitively expensive. That situation has definitely changed since the beginning of the 1990s. Indeed, our performance numbers suggest that even the most conservative investor should add some call purchases to their portfolios. Even when markets are volatile, it is possible to find attractively priced calls, if you know where to look.
When you buy a call, you pay a premium for the right, but not the obligation, to buy the underlying stock at a specified price - known as the strike price - until a certain specified date - known as expiration date.
At Value Line, we base our call buying recommendations on a combination of our expectations for the common stock (usually rank 1 for highest performance) and the pricing of the call itself. The less expensive (i.e. cheap) the call is in terms of the risk of the position, the better we like it.
What makes a call cheap or expensive? What we are really talking about is an option's time premium. Time premium is that part of an option premium that is not "intrinsic" value. Think of time premium as insurance against making the wrong financial decision.
There are five "known" variables (stock price, strike price, time to expiration, dividend rate and interest rate) and one "unknown" (or estimated) variable - volatility - that gives an option its time premium. More specifically, this "unknown" is the expected range or dispersion of the stock price over the life of the option. (For a discussion of volatility, see our recent report, "Understanding Our Volatility Forecasts.")
An Internet stock such as NVIDIA can be twice as volatile and have twice the time premium as a Brokerage stock such as Goldman Sachs. As of April 4, 2006, we were recommending calls on both stocks, based on each stock having a Timeliness rank of 1 and having options that were underpriced, according to our model.
Calls with cheaply or reasonably priced premiums can be very attractive investments. In terms of risk versus reward, calls can run the gamut from those that trade very much like the underlying stock to more leveraged positions that only pay off if the stock makes a big move.
An In-the-Money "Deductible"
An in-the-money call is one in which the stock is above the strike price; thus, the option has tangible value. In addition, this option has time value. This time value is insurance against the stock going below the strike price. Think of the difference between the stock and the strike price as the "deductible" on an insurance policy and you will get the concept. The lower the strike price on an in-the-money call, the more the investor can lose and the lower will be the time premium that he or she needs to pay.
Take at look at (Graph 1). Here we have the $12.50 strike August call on Integrated Device with the Stock at $15.00 (as of April 4, 2006), priced at $3.05. The most you can lose on this position is this $3.05, which consists of $2.50 worth of tangible value and the option's $0.55 time value, which is, in effect, insurance against the stock going any lower. If you wanted to pay less for insurance, but were willing to live with the possibility of a larger loss, you could buy a call that is even further in-the-money (i.e. with a lower strike price) and that has even less time premium.
At-the-Money: Insurance in Both Directions A call that has a strike price that is equal to the stock price is known as an at-the-money call. Naturally, for an at-the-money call, which is insuring any loss below the current stock price, we pay a higher time premium than we would for the in-the-money call, which only insures against losses beyond a certain drop in the stock.
However, when you buy an at-the-money call, you are also buying insurance against the stock going up! This is because you can participate in all gains in the stock above the current stock price. After the fact, you will not have to say; "I wish I had bought that stock"
Look at (Graph 2). Here we show the P/L on the at-the-money $15 strike August call at $1.35 on this same stock. The most you can lose is the $1.35 time premium you paid for this option (no deductible). Alternatively, on the upside you get to participate in profits above the current stock price (again no deductible).
Out-of-the-Money: Insurance Against Not Buying the Stock
You can also buy a call in which the strike price is higher than the stock price. This is known as an out-of-the-money call.
Look at (Graph 3). In the example we have bought the $17.50 strike August call on Integrated Device at $0.45. At expiration, you only make a profit if the stock goes above this $17.50 strike price. Here the difference between $17.50 and $15.00 is your deductable. On a certain level, an out-of-the-money call can be highly speculative, since there is a good chance that it can expire worthless. However, if you want to be mainly invested in cash and bonds, but want some insurance against missing out if stocks rise, then out-of-the-money calls can be the way to go.
Your Best Call?
Which call is best - in-the-money, at-the-money or out-of -the-money? That depends on you're your risk/reward appetite. With an in-the-money call, the stock doesn't have to rise by very much for you to start making a profit, but you are taking a position that is a bit more like owning the stock with some of the same downside. With an at-the-money call, you have no downside exposure - and you are also insured against missing out if the stock rises. However, you pay the highest time premium for this "two-way" coverage. With an out-of-the-money call, you can get a very handsome return if the stock makes a big move, but you also run the very real risk of the option expiring worthless.
Which of these options do we recommend? In fact, our model has no bias for in-, at- or out-of the-money calls. If the premiums are attractively priced and the underlying stock is highly ranked (by Value Line), then the calls are likely to highly ranked 1 as well. What we often find is that a lot of the bargains are in the less glamorous in-the-money calls, while a lot of the less attractively priced calls (i.e. those that are overpriced) - are among the more glamorous highly leveraged out-of the-money calls.
Often, you have to look at the options that are being ignored by the market to find the best bargains.