OPTIONS
In The Great Profit Hunt
Using Calls To Create Synthetic Leverage
by Matthew J. Stander
Before you take the plunge and buy a call option, you should
consider whether you know everything you can about doing so.
Traders frequently buy call options to increase
returns on long positions without first taking the time to understand the
complexities of option pricing. For a sophisticated options trader with
the ability to change positions in milliseconds, pricing models like Black-Scholes
provide valuable guidance for establishing derivative positions. However,
most traders could benefit from other analytical techniques that avoid
the intricacies of complex calculus and cumulative log-normal statistical
distributions.
Analyzing calls based on the synthetic leverage they create is a powerful
way to understand how in-the-money call options can benefit you. A better
understanding of how call options create leverage will help you determine
when to use calls and which call to buy. Modifying long trading strategies
to use in-the-money call options for leverage may make your trading strategies
much more appealing.
UNDERSTANDING LEVERAGE
Comparing the cash flow of buying a call with the cash flow of borrowing
money to purchase a stock is the best way to understand how calls create
leverage. An American-style call option gives the buyer the right to purchase
the underlying equity at the predefined strike price on or before the expiration
date. When a trader purchases a call option, he or she pays the asking
price for the call (C). If the stock price (ST) at the time (T) is greater
than the strike price (X) and the trader simultaneously exercises the call
and sells the underlying equity, the trader receives the difference between
the stock price and the strike price.
Under normal circumstances, selling a call prior to expiration will
return more than simultaneously exercising and selling the underlying equity.
For simplicity’s sake, however, let us assume in this example that calls
are sold just before expiration, capturing only the difference between
the stock price and the exercise price. If the stock price is less than
the strike price, the trader receives nothing. Figure 1 shows the two potential
cash flow diagrams for purchasing a call option.
FIGURE 1: CASH FLOW DIAGRAM FOR PURCHASING A CALL OPTION.
Assuming you sell your calls just prior to expiration and the stock
price minus the strike price is greater than the price of the call, your
return will be positive. If the stock price is less than the strike price,
you will end up with a loss of the capital used to purchase the call.
...Continued in the March issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the March 2006
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2006, Technical Analysis, Inc.
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