Is the out of the money call better? Got a question from a member recently:
I have been looking at stocks, and 1 expert says UNP has the highest value in the s&p 500. It appears to be doing well.
Please look at the calls with me.
The jan 2012 leap, at 60. I believe is selling at 33, which puts it at 93 and is trading at 93.5. If you expect it to go to 100 by then , the gain should be 6.5 $ for a 33 $ investment or about 19.7% over 10 months?? Am I seeing this correctly?? and the math right ??? It appears that the in the money option is a better value than the out of the money ??
A 7 % move giving a 20 % gain????????
Looking at the 100 call, jan 12, it sells for about 5.80. If it closes at slightly over 100, you may get a dollar gain ??????? or actually, break even is at 105.8?????
What is the correct way to compare an itm vs an otm trade? I guess that is my real question????
So I looked at the stock to answer his question. The numbers had changed a bit.
UNP was at 95.60 when I looked at it. The Jan 2012 60 strike call was trading at $36. That makes the breakeven $96. The delta on the 60 call was .89. That means the option will gain 89cents for every $1 gain in the stock price. So if UNP is at $100 at expiration, the stock will have gained 4.4% while the option will have gained 11.11%. The return will be better if the stock does well.
Buying a call so far in the money is also called “stock replacement”. You are putting up less money to buy the call and get about the same gain/loss in the option that you get in the stock. Using far in the money options is a great idea when doing covered calls. Since the cost of the long call is cheaper than stock, your returns on the covered call are much greater.
For the At the Money 100 Call, it is trading at $7, so the breakeven is $107. But if UNP goes past $107, the gains will be of a greater percentage.
Say UNP is at 110 at expiration. For the In The Money Call we would make $14 or 38%. With the At the Money Call we would make $3 or 42.8% While the stock moved up 15%
Which one should you choose? The In the Money is the most conservative since it is at about breakeven right now and can gain more than the stock if the stock advances. The At the Money Call is fine if you think the stock will move. In our example I only took the stock to $110. It the stock is at $120 at expiration, the At the Money Call % return would have dwarfed the other two options.
That being said, would you want to wait for almost a year to make 20-30% on these calls? If UNP is going to go up, why not sell Puts month after month and make 8-10% a month? That way, even if UNP stays close to $95, or moves up, or even moves down a little, you can still make money. And if UNP moves down a lot, you just look for another stock. You are not tied into the trade long term like with these calls.
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