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Strategy Discussion - Buying Calls

The First Task

It turns out that the first question a call buyer should ask him or her-self, is: At what price do I expect this stock to be trading at option expiration? Once an answer is given, the choice of call strike price is greatly simplified.

But call buyers do not always have a precise target price. They may be looking at DOG and thinking “My target price is in the 112 to 114 range.” In this latter scenario it may be useful to calculate the cross-over points, that is, the stock price at expiration where the return on capital from two different call options are equal.

The return from purchasing a call is equal to [(Stock Price at Expiration - Strike Price) / Purchase Price] -1. In the DOG example, the return on the 90 call is [(Stock Price at Expiration – 90) / $11.38] -1. The return on the 100 call is [(Stock Price at Expiration – 100 ) / $4.85] -1. The cross-over point is the stock price at expiration where both returns are equal, or where:

Basic algebra will give us $107.43 as the cross-over point; at that price both the 90 and 100 calls will show a return on capital of 53.2%. Using the same technique we find that the cross-over point between the 100 and 110 calls is $114.56 where both options return 200%.

Armed with our cross-over points we are now in a better position to choose our call’s strike price. If we expect a moderate rally to the 107 - 108 range, the 90 calls appear to be the better fit. A forecast of 112 – 113 would have us opt for the at-the-moneys and a $116 (or higher) target would lead us to favor the 110s.

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