You are bullish on Puppy Dog (DOG) currently trading at $100. You think this is the perfect opportunity to purchase 49-day call options, pull up the option chain and get the following:
June 90 calls: $11.38
June 100 calls: $4.85
June 110 calls: $1.52
Which option should you buy? In-, at-, or out-of-the-money? For a given dollar investment you can purchase fewer of the 90 calls, more of the 110s. Isn't owning more calls better than fewer? The clue to your decision here, are the words for a given dollar amount. If you are going to risk x dollars on this trade, what is your objective? To generate the highest return on your capital at risk.
So let’s assume that you are willing to risk $4,000 on this trade. Given the above call prices you could purchase 3.51 of the 90s, 8.25 of the 100s or 26.3 of the 110s. You cannot purchase fractional options, but this will not impact our analysis as we will be looking at returns.
So which call should you purchase? The answer: it depends. Assume that DOG rallies 5% by the option expiration date. The returns from buying each of the 3 calls are summarized below.
In retrospect, the “best” call to purchase was the 90. It shows a nice return on capital risked while the 100 call barely breaks even and the 110 expires worthless.
But what if DOG rallied not 5%, but 10%, to $110? We would revise the results as follows:
Now, both the 90 and 100 calls are showing substantial returns, the 110s have yet to make us a nickel, but the 100s come on top as far as return on capital at risk.
Finally, what if DOG breaks loose and rises 15%, to $115. We would now get the following results.
Now all 3 calls show great returns with the 110 leading the pack. So the decision as to which call to purchase should be a function of the forecasted price of the underlying at expiration.