Educational Programming Video
The Value Line Daily Option Survey
Program 2: Buying Calls
The subject for our second session is buying calls. Should you buy calls? Many people say you shouldn't, but we beg to differ. Over the past ten years, our recommended calls have paid off handsomely. What's more, our data suggests strongly that even the most conservative investors should add calls to their portfolios.
When you buy a call, you pay a premium for the right but not the obligation to buy the underlying stock at a specified priceknown as the strike priceuntil a specified dateknown as the expiration date. We base our call buying recommendations on a combination of the Value Line common stock ranks, usually 1 for highest performance, and our model's estimation of whether the call is cheap or expensive.
What do we mean by cheap or expensive? What we are really talking about is an option's time premium. Time premium is that part of the option premium that is not "tangible" or "exercise" value. If you think of it as insurance against making the wrong financial decision, you can understand the principal. Time premium is a function of five "known" variablesstock price, strike price, time to expiration, dividend and interest rate and one so-called "unknown"the expected future volatility of the stock. We will talk more about volatility later in the series. However, for now, you should understand that we use a proprietary model to estimate a stock's future volatility and to determine whether time premium is cheap and worth buying - or expensive and suitable for some other strategy.
Underpriced or cheap calls on bullish stocks can be very attractive investments because they insure not only against loss but also against missing out on potential profits. We will illustrate this point with examples of in- at- and out of the money calls.
An in-the-money call is one in which the strike price is below the stock price. The premium on an in-the-money call consists of "tangible" or " exercise" value and time premium. Tangible value is what you can get if you exercise the option, while the time premium is the insurance that if the common drops below the strike price, you no longer have a long position in the stock. The more the call is in-the-moneythat is the lower the strike price and the greater your potential lossthe lower will be your time premium insurance. If you think of tangible value as your deductible and time premium as your insurance, you will get the concept.
An at-the-money call is one in which the strike price is equal to the stock price. Think of this option as insurance with no deductible since the most you can lose is the premium you pay. But also understand that you have insurance against missing out if the stock rises, since the call immediately begins to acquire "tangible" value as the stock goes up. Naturally, this at-the-money time premium is higher than the in-the-money call's time premium. In fact, for calls on the same stock with the same maturity, the at-the-money call always has the highest time premium.
An out-of-the-money call is one in which the strike price is higher than the stock price. You can think of an out-of-the-money time premium as insurance against missing out if the stock makes a big move. As with the in-the-money call, the deductible is the distance between the stock and the strike price. In this case, it's the portion of the stock's rise that you would be willing to forgo. Naturally, the further the call is out-of-the-money (i.e., the greater the deductible) the lower will be the time premium. Because out-of-the-money time premiums are often nominally cheapsometimes as low as 1/8 a pointthey are very popular with speculators. But, you have to realize that these options have a high probability of expiring worthless.
Which call is bestin-the-money, at-the-money or out-of-the-money? That depends on what you want to insure. Is it a position in the stock but with a downside deductible as with the in-the-money call? Or is it insurance against missing out if the stock makes a big move as with the out-of-the-money call. Or do you want it both ways as with the at the money call?
Which of these options do we recommend? All three are fine and, in fact, our model has no bias for any particular type. If the premiums are attractively priced and the underlying stock is ranked 1 by The Value Line Investment Survey, then the calls are likely to be ranked 1 as well. What we do find is that different calls are attractively priced at different times. Often, it's the options that are being ignored by the rest of market that offer the best value and the ones that everyone else is buying that are overpriced and unlikely to be profitable.
Every day, our model selects as many several hundred calls that are suitable for buying. Over the past ten years, a portfolio consisting of 15% recommended call purchases and 85% interest bearing cash could earned better than 60% per annum while beating the market 70% of the time.
In our next report, we will talk about buying puts, which give you the right but not the obligation to sell stock at the strike price. You will see how Value Line's ability to select stocks that are likely to underperform plus our model's ability to pick underpriced puts can help you reduce the volatility of your investments.