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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