Call Options in a Nutshell

What is a call option, and why should you know about them? A call option is a investment tool used to in essence bet on the price of a stock in the future – read some more details about this type of transaction here. People buy and sell these because they can get a huge return for a small investment or receive small payouts for holding shares of a company with the risk of having to sell the stock at a certain price.

Simple example below for buying a call option using real prices as of today.

You buy a call option for Google that expires the middle of next month (October 19th, 2013). The strike price for which you buy the option is $900 and you pay $14.60 per share for the option (options are bundled into stacks of 100 shares so you will pay $1,460 total). The person who sold the option to you immediately receives around $1460 for their holding of 100 shares currently valued at $860 per share or $86,000. This means they immediately get almost 1.7% of their entire holding of the stock in cash.

Why would anyone pay $1460 for this option? See the three example outcomes below:

Google goes up to $950 by October 19th – the buyer of the call option will receive $50 per share for his option ($950 – $900). That means he will have made $5,000 minus what he paid for it ($1,460) for a total of $3,540 in profit. That equates to more than 340% returns on investment, a hefty profit indeed. The seller of the option will be forced to sell the stock at $900 per share, so he is losing out on $5,000 but still has to consider what he made from writing the option ($1,460) which puts him at losing the potential $3,540. Luckily, he is still making money since the stock has risen above $860 so he makes $40 per share plus the price he wrote the call option for totaling $5460.

Google remains at $860 by October 19th – the buyer of the call option loses everything, since the option did not reach the strike price. The writer of the option keeps what he made from writing the call option ($1,460). The writer also does not need to sell his stocks.

Google plunges to $500 per share – the buyer of the call option is only out what he put in ($1,460). The writer of the call option did not sell his shares since he has a option on his holdings and doing so before he buys back his call option puts him at infinite risk. He gains $1,460 more than if he had held the shares and not wrote the option, but has lost $36,000. His total losses are $34,540.

Now, consider the optimal situation for the writer of the call option – The stock climbs to $949 per share before expiration, a dollar short of the strike price. If this happens the seller can go ahead and write another call option for the same shares for the next month!

The optimal situation for the buyer of the call option is for the stock to skyrocket of course, so he can make profits on his investment.

The lose-lose situation is if the stock plummets, although you may argue that the writer of the call option still comes out better than if he didn’t write the call option if he was going to retain the stock either way.

Why Save Now?

The reason people save money is so that they can be independent, and not need to depend on the whims of government for their survival. Personally I don’t think anyone should rely on social security benefits to aid them in their waning years – in fact I think It’s important to not have to worry about money when you get older so you can enjoy the better things in life. That is why I get to this topic – first reason for saving should be securing yourself in the present. If you get fired from your job or if a family member gets sick and you need to cover medical expenses then this is a no brainer. Build up your emergency fund, as detailed in my previous post. After this build up your investment accounts, include among them a retirement investment account.

If you have no intention to use investment money until you retire, then go ahead and put all your savings (outside of the emergency fund) into a tax advantaged retirement account such as a Roth or Traditional 401k/ IRA. If you don’t know the difference, Roth 401k /IRA’s contributions are post-tax and the traditional 401k/IRA are pre-tax. When you cash out your Roth’s you won’t be taxed again, but when you cash out your traditional’s, you gotta pay whatever the tax rate is at the time.

You might consider splitting your retirement investment accounts in half, just in case taxes are worse in the future. The benefits of a traditional are immediate, as your taxable income is decreased based on how much you contribute to it. To find out more detailed information on this please visit here.

Now, to the juicy part – if you can score a 10% return on your investments then $1 today will be worth $45.26 forty years from now. How do I know that? According to math, the calculation for future value is (1 + k) ^ n , where k is the rate of return, and n is the number of periods. I’m keeping it simple, having the compound period equal the return period. You can learn more about future value here.

So investing early will score you big points with yourself when your in your 60′s begging yourself to retire. Take a look at a great chart that goes through the possible outcomes of your one invested dollar based on different rates of return without having to use a calculator here. I’ve taken the liberty to display a 10 percent rate of return over time using Google Docs and how it changes $1.

1 dollar over 59 years

Accumulate Non-Digital Value

Part of safeguarding yourself against scenarios that may arise based on political whims, such as levies on bank balances or identity theft related money transfers, is to store physical value. Gold has long been the “gold standard” in storing value, and is a great investment item, additionally you can consider investing in silver and even copper or other metals if you have sufficient storage space and means to protect the storage space. That gets me to the next item on the list, the means to protect your items and your self – be it through rigorous physical training or purchasing a home defense weapon. The latter can also be a store of value – one will find that such items do not depreciate quickly.

Why Save?

What is the point of amassing fortune, why save at all? One word – independence. You don’t want to be a slave to credit companies or banks, you want to be free to do what you want when without having to take it from the government or wait for it in a huge line. Conversely, you should not make wealth accumulation the top priority of your life, it is only a tool to do what you want to do and if you have a family the rewards are multiplied. Want to go on an international vacation with your whole family? This will cost you – for example if you want to stay in reasonably accommodations for two weeks in England from the US you should be willing to spend $20,000 to enjoy your time there and not have to share a restroom and live like a hippy. It is important through all this to realize that having money is not the purpose of having money – unless of course your name starts with Ebenezer.

Don’t Invest In Chinese Stocks – Unless You Know Exactly What You’re Doing

The Chinese economy is the second largest in the world, and has been growing at an impressive rate for the past 20 years. However, China has in the past few years taken measures (like those of the US that led to economic bubbles) that will eventually pop. Also, China’s one child policy has for the first time since the 1960′s resulted in a shrinking labor force and a top heavy (age-wise) population that will only get worse as long as the law is in place.

That means that you will see a large reversal in their stock market prices once the pop happens, the problem is timing the pop. As I am a fan of safe investing and treating money with care instead of gambling (an exorbitant amount), this is an area of investing I will steer clear of.

In regards to investing in US Stocks, you also need to know what you’re doing and stick away from low market capitalization stocks or ones that sound fishy such as exploratory mining stocks or small shipping companies – check that your market capitalization is at least $1 Billion USD.

First Step

You cannot protect your wealth if you have no wealth to protect. The first step in the process is to build up an emergency fund to keep you alive if the rainy day should happen. I’d recommend around $5,000 for an individual, $8,000 for a couple and $10,000 or more for a family with kids – you can also use an online calculator and add $1,000 to this result. Keep this in liquid assets. Along with the liquid assets you should have a months worth supply of water and food in case the unexpected should happen in your area.