How to Use Call Options for Gains - dummies

How to Use Call Options for Gains

By Paul Mladjenovic

Out of all the vehicles and strategies an investor has, the simple call option (or the long call) has the biggest bang for the buck for bullish speculators. There are two basic considerations for success in using call options to make big gains: content (the underlying asset) and timing.

The underlying asset is key

The big secret to success with options actually has little to do with options; success ultimately depends on the underlying asset. You don’t have to be an expert with options, but you should be as proficient as possible with the underlying asset.

An option is not an investment or asset; it’s a derivative. That means that it derives its value from something else. If the underlying asset is doing well, then the call option will derive value from that. If the underlying asset is having a bad day, then the attached call option will have a really bad day.

One speculator opened a futures account with $90,000 in February 2004. He decided to buy call options on a commodity: oil. He didn’t know call options as well as he knew the oil market. As you may know, 2004 was a bullish year for oil. How did this speculator do?

By December 2004 (less than 11 months later), that account was worth about $1.1 million. That doesn’t include more than $300,000 that he took out of the account during the year to cover some of his living expenses. This is a spectacular — and true — example of what you can accomplish if you thoroughly research a market and understand its fundamentals (supply and demand and such).

Now, keep in mind that you don’t have to speculate with such a large amount. Percentagewise, you could have had similar results with much less.

Timing is everything else

Options sometimes seem to observe Murphy’s Law. If you buy an option that will expire in five months, the event you’re waiting for will happen in the sixth month. In other words, although you could be totally right about an asset going up, you might get in too soon or fail to buy an option with enough time on it.

If you have a choice between buying ten options with a six-month time frame or two options with a ten-year time frame, definitely choose the latter. One person who bought 100 call options on a high-profile stock that were expiring in about three weeks, but the desired outcome came much later. Meanwhile, those (very brief!) options expired worthless, and she lost $32,000.

Options that are called Long-term Equity AnticiPation Security (LEAPs) have a shelf-life of one, two, or three years — possibly longer in some markets.

Timing your entry and exit points will increase your chances of success. Keep these points in mind when you’re ready with your option order:

  • When possible, buy a call option on a down day for your chosen asset. Options react to market volatility (up or down), so make that movement work for you. When an underlying asset is being hammered in the market, the options attached to it will be doubly hammered. That means a good buying opportunity for options.

  • When possible, write (sell) your covered call on an up day for your chosen asset. When an asset is having a strong up day, then the attached options will be higher, indicating an opportune time to write an option.

  • Buy multiple contracts. Seasoned traders buy multiple contracts so that they can cash out some to lock in a profit while allowing a few contracts to hang on for more potential gains.

  • Lock in profits. Options can be a great way to build wealth, but they aren’t a good way to preserve wealth. When you’re sitting on big gains (or just gains period!), take some chips off the table. No one was ever hurt taking profits. An option is ultimately a wasting asset that can lose value, even when the underlying asset looks strong and profitable.

    When you start seeing gains, slowly cash in and seek to recoup your original investment. If you started speculating in options with $5,000, then take advantage of nice gains in your account to remove $5,000 and shift that money to cash or long-term investments (such as stocks, remember those things?). You’ll be glad you did.

  • Keep your emotions in check. Holding options is like holding a lit match — will you keep holding on until you’re burned? Options can magnify not only gains or losses but also emotions. Fear and greed are regular parts of the options market, so discipline is crucial for long-term success and sanity.

    One speculator opened a futures account and funded it with $2,300. He bought gold call options. Gold went up sharply, and in four weeks his account was worth $80,000. He had the opportunity to cash out some of his positions but didn’t do so. What happened then? In the subsequent four weeks, gold fell by the same amount, and his options value shrunk to $22,000. Now if you only knew that he went from $2,300 to $22,000 in eight weeks, you might be impressed. But he’s probably kicking himself for not cashing out some of his positions when the value was around $80,000. The only thing worse than losing money with options is having gains within your grasp and then losing them.