The most
basic of options strategies is to simply buy call or put
options. When you buy options, you are said to have a long position in that
option. You have a long call position when you buy calls or a long put position
if you buy puts.
Generally,
when you are bullish on the underlying asset, you can buy call options to
implement the long call strategy and when bearish, you buy put options to
implement the long put strategy.
In both
cases, you hope that the underlying stock price move far enough to cover
the premiums paid for the options and land you a profit.
Cost Considerations When
Buying Options
The price
you pay to own the option is called the premium which is affected by many
factors such as moneyness, time to expiration and underlying
volatility.
Moneyness
Out-of-the-money
options are cheaper to buy than in-the-money options but they
are also more likely to expire worthless.
For call
options, this means that the higher the strike price, the cheaper the option.
Similarly, put options with lower strike prices are therefore less expensive to
purchase.
However,
the size of the premium alone does not tell us the whole story. In
fact, at-the-money options can be considered the most expensive even
though their premiums are lower than in-the-money options. This is because
their time value is highest and time value is the part of the premium
that will waste away as the expiration date approaches.
Time to Expiration
Obviously,
the longer the time to expiration, the more chance the option buyer have for
the underlying price to move in the right direction and therefore the more
expensive the option.
Selecting the Right Option to
Buy
Which
strike price and expiration you choose all depends on your outlook of the
underlying. For instance, if you believe that the underlying will make an
explosive move upwards very soon, then it makes sense to buy an at-the-money
call option expiring in the nearest expiration month.
Buying Options for the
Purpose of Hedging
Other
than speculation, options can also be bought as a means to insure potential
losses for an existing position in the underlying. To hedge a long underlying
position, a protective put can be purchased. Similarly, to protect a
short underlying position, a protective call strategy can be used.
