In this article , you will learn that:
- Options are wasting assets with time value
- A catalyst is very important when it comes to buying a call option
- A real life case study on buying a call option with a catalyst
Call options are wasting assets
Call options are wasting assets. In the absence of any movements in the underlying security’s price, a call option will diminish in value over time. This is especially so during the last 60 days of an option’s life as the time value decreases at a faster rate as it approaches expiration date.
Buy a call option when there is a catalyst
A catalyst is an event that will cause the stock price of the underlying security to move. In the case of a call option, an options trader would want a catalyst that will cause the underlying security price to move upwards.within the life of the option, failing which, the option will expire worthless and the options trader loses the entire option premium paid for the option.
At the time of this writing facebook was trading at about $103. Its quarterly earnings was going to be announced in a matter of days. If a trader were bullish about Facebook and predicts that there was going to be a positive earnings announcement, a trader may choose to buy a call option before the earnings announcement, with the expectation that the earnings announced would catalyse the share price of facebook upwards.
He decides to buy a current month call at a price of $4.20.
When the earnings was announced, the price of Facebook spiked upwards to about $109.
The headlines from CNBC:
Facebook earnings : 57 cents per share, vs 52 cents per share
And the most salient reason as to why there was a jump in Facebook’s price was because analyst estimates were calling for 52 cents per share. This was an earnings surprise to the upside. In fact, Facebook’s revenue for the quarter was driven mostly by mobile advertising sales and and increased user growth.
As you can see from the above charts, there was a gap up in price to approximately $109.
This caused the current month call at a strike price of $103 to increase to a value of $6.90.
In a matter of days, the trader would have made a profit of :
($6.90 – $4.20) x 100
= $2.70 x 100
The trader has made a profit of $270 in a matter of days.
The percentage profit or the return on investment is:
$2.70/$4.20 x 100%
This is a decent return for a very short period of time. This proves that options traders can use options as a leveraged tool to achieve phenomenal returns over a short period of time.
Traders who want to buy call options must consider the erosion of time value in an option. That is exactly the reason why traders should look for a catalyst that will cause a significant price move to the upside which will in turn cause the option premium to increase. When that happens, the trader could sell to close the position at a profit. In the absence of a catalyst, the call option could possibly expire worthless and the trader loses the entire premium paid for it. In this case, the reported earnings was the catalyst as analyst estimates were exceeded.