Downside of Buying Call Options

Call Options

Take another look at the call option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $53.10 is.

Call Options need Big Moves to be Profitable

Putting percentages to the breakeven number, breakeven is a 6.2% move higher in only 30 days. That sized movement is possible, but highly unlikely in only 30 days. Plus, the stock has to move more than that 6.2% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of buying 100 shares outright and buying 1 call option contract ($52.50 strike price) will be given:

100 shares: $50 x 100 shares = $5,000
1 call option: $0.60 x 100 shares/contract = $60; keeps the rest ($4,940) in savings.

If the stock moves 2% in the next 30 days, the shareholder makes $100; the call option holder loses $60:

Shareholder: Gains $100 or 2%
Option Holder: Loses $60 or 1.2% of total capital

If the stock moves 5% in the following 30 days:

Shareholder: Gains $250 or 5%
Option Holder: Loses $60 or 1.2%

If the stock moves 8% over the next 30 days, the option holder finally begins to make money:

Shareholder: Gains $400 or 8%
Option Holder: Gains $90 or 1.8%

It's fair to say, that buying these out-of-the money (OTM) call options and hoping for a larger than 6.2% move higher in the stock is going to result in numerous times when the trader's call options will expire worthless. However, the benefit of buying call options to preserve capital does have merit.

Capital Preservation

Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Buying call options and continuing the prior examples, a trader is only risking a small 1.2% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss of 5% is easier to take for an option call holder than a shareholder:

Shareholder: Loses $250 or 5%
Option Holder: Loses $60 or 1.2%

For a catastrophic 20% loss things get much worse for the stockholder:

Shareholder: Loses $1,000 or 20%
Option Holder: Loses $60 or 1.2%

In the case of the 20% loss, the option holder can strike out for over 16 months and still not lose as much as the stockholder. Moreover, the stockholder now has to make over 25% on their stock purchases to bring their capital back to their previous $5,000 level.

Moral of the story

Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options have many variables. In summary, the three most important variables are:

The direction the underlying stock will move.
How much the stock will move.
The time frame the stock will make its move.