In-The-Money, At-The-Money or Out-of-The-Money Calls?

Buying calls is generally the first strategy employed by novice option investors. This simple and easy-to-understand strategy can be very profitable as it provides leverage and limits the risk to the option premium. However, it can be frustrating for the investor who pays no attention to certain factors.

Call buying is a bullish strategy and can be used as an alternative to buying the stock itself. For only a fraction of the capital needed to buy the stock, investors benefit from leverage if their bullish outlook materializes. The objective of call buyers is to maximize their return on investment. Before entering into any purchase, investors must determine: the amount to invest, the target price for the underlying stock and the time horizon within which they think the stock will hit the target price.

The amount to invest clearly depends on the size of the investor's portfolio and his or her risk tolerance. One has to be very careful concerning the amount to invest because leverage can be a two-edged sword: it substantially increases returns as well as losses.

Depending on their target price for the underlying stock, investors must decide which option to use among the different strike prices available: in-the-money, at-the-money or out-of-the-money. Out-of-the-money options may seem attractive since they are less expensive. However, remember that there is a reason for this: chances of profit at expiration are slimmer than for at-the-money or in-the-money options. There is no best choice. The choice of a strike price mainly depends on the target price.

Here is an example to illustrate this point. On October 25, 2004, EnCana trades at $59.95. A bullish investor considering a call purchase may choose from the following:

December $57.50 ECA call: $3.70 (in-the-money)
December $60.00 ECA call: $2.15 (at-the-money)
December $62.50 ECA call: $1.15 (out-of-the-money)

Which call will yield the best return?

If EnCana's target price for the month of December is $65.00 and if that price is reached at expiration, the at-the-money option will be the best choice with a 133% return, compared to 103% for the in-the-money option and 117% for the out-of-the-money option.

However, for a target price of $63.00, the in-the-money option becomes the best choice with a 49% return, versus 40% and -57% for at-the-money and in-the-money options respectively. In the end, if the target price is much higher, as in our example whereEnCana closed at $68.10 at expiration, out-of-the-money options are the most attractive with a 387% return, versus 277% and 186%for at-the-money and in-the-money options respectively.

What can be learned from this?

Out-of-the-money options perform better with a substantial increase in the price of the underlying stock; however, if you expect a smaller increase, at-the-money or in-the-money options are your best choices.

Bullish investors must have a good idea of when the stock will hit their target price—the time horizon. More often, when buying short-term options, investors may have the unpleasant surprise of seeing the stock price soar but only after the expiration of the calls they own. By buying a longer expiration, investors leave nothing to chance and they can always get out of their position sooner if their objective is attained.

Last, investors must carefully look at the implied volatility of the option at the time of purchase. It is reflected in the premium. Ultimately, options are purchased when implied volatility is low and sold when it is relatively high. Investors who buy an option with higher implied volatility often pay too much for the option. Despite an increase in the underlying stock price, the price of their call can decrease following a decrease in the implied volatility.

Source : Montréal Exchange – New Options Newsletter