Thu Mar 20, 2008: Financing Your Call Purchases

Call option buyers can make large profits if the underlying stock moves up quickly. If it doesn't, they can (and often do) lose all of their investment.

Here's one approach that can help by generating some option income to offset that potential loss. The idea is to sell out of the money puts in an equal dollar amount to the out of money calls that are purchased. This way, if the stock does not move up and the call options expire worthless, some money can be recovered by waiting for the puts to expire.

This assumes that while the stock does not go up sharply, it does not decline sharply either, or else there could be an additional loss on the short puts. The expectation is that you're getting the direction of the next major move correct, you're just not sure of the timing. If the strategy works, there will be enough income from the puts to provide another opportunity to try again, buying calls for a different month some time in the future, if the expected up move does not happen right away.

The intention here is to leverage up the call purchases for maximum profit but set up the put sales for a safer, less leveraged income. It's not buying at the money calls and selling at the money puts with the same expiration date -- that would be a synthetic long position roughly equivalent to simply purchasing the stock.

Let's look at an example using the stock of Goldcorp (NYSE-GG, 37.31) which made a recent high of 46.30 three days ago before its sharp correction.

Chart of GG stock

Selling five of the July 35 puts at the current price of 3 would provide $1,500 of income. Ignoring commissions, an equivalent dollar amount of calls to purchase could be 25 of the April 42.50 calls at 0.60 each. This would provide high leverage for four weeks. If during that time GG recovers back above 42.50 the calls will retain some value, with a breakeven point at 43.10 and theoretical profits as follows:

44.10: +$2,500

45.10: +$5,000

46.10: +$7,500

47.10: +$10,000

48.10: +$12,500

49.10: +$15,000

Note that to implement this strategy you need to have money up front to fund both the call purchase price and the margin requirement for selling the naked puts.

If the stock stays below 42.50 the call options will expire worthless on Friday April 18th. In that case the idea would be to wait until July expiration to get your "refund" from the July 35 puts expiring worthless. But if GG continues falling and stays below 35, those puts will have to be bought back or allowed to be exercised. The breakeven point on the puts is 32.

Until next time, best of luck with your option investments!