…if held to maturity. Of course, while many buyers of call options will exercise or sell their options before expiry if the options trade in-the-money, let’s pretend for this discussion that one holds the option until expiry.
Michael James on Money mentioned that he thinks it is generally a bad idea for the average investor to buy options, and I would be inclined to agree. Long options (long means you buy something, short means you sell it) can offer tremendous leverage which means you magnify the risk and return. It is estimated that approximately 80% of call option contracts, if held to maturity, will expire worthless.
But let’s look a little more closely at a real world example. I’ll use Royal Bank as an example since it is very liquid, but this is not a recommendation to buy, sell, hold or not hold Royal Bank stock or options.
At the time that I am writing this post, RY (ticker symbol for Royal Bank common stock) is trading for $44.33 per share. There is an August 2008 Call Option on RY with a $50 strike price which last traded for $0.30. If you were to purchase this call option your outlay would be $30.00 ignoring commissions (option contracts are for 100 shares). If RY trades above $50.01 at expiry, then you would exercise your option (or sell it) since it would now be trading “in the money”. You wouldn’t realize a profit unless RY traded over $50.30. If RY trades for $50.00 or below at expiration, then you would just let the option expire worthless and you will have lost your initial $30 forever.
Because there is only 32 days until expiry and RY shares would have to appreciate by 12.79% (which would normally be a rare proposition for RY historically), there is not much value in these options, hence the relatively cheap price of $0.30 per share. The option market is predicting a volatility of 29.61% for this 32 day period for RY – which equates to the market’s expectation that the probability of this option ending up in the money is only 7.2% (according to an option probability calculator).
But what about a $50 call option with more time, i.e. a $50 call option that expires in January 2009. In this case we have 184 days until expiry instead of 32. You would think that since there is more time, there is more of a chance that the option will end up in the money. The option market believes that the volatility of RY during this period will be slightly lower at 27.48% (which when taken with the higher implied volatility during the next 32 days indicates that the market thinks RY will become less volatile over time). According to the option probability calculator, there is a 25.6% chance that this option will end up in-the-money. But this doesn’t mean much until we know the price of this longer duration option. As it happens, it last traded for $1.85, which means your outlay would be $185. Even though this option has the same strike price of $50 it is worth more since there is more time for RY to hit $50.
Let’s now turn to a more volatile stock, RIM (Research in Motion). Again, this is not a recommendation to buy, sell, hold or not hold RIM. Randomly selecting a call option I picked a December 2008 $150 call option. RIM, at the time of writing, last traded at $115.26. Based on the market’s implied volatility of 50.60%, there is an estimated 17.9% chance that this option will end up in-the-money, which is line with the rule of thumb that 80% of call options if held to expiry will expire worthless.
Implied volatility requires more explanation, but it will need a few posts and I will tackle it when I get back from my trip. In the meantime, consider that when you just buy 100 common shares of RY, the chances of you losing all your money during the next 32 or 184 days is pretty remote. Perhaps your expected range of returns would be between -15% and +15%. Conversely, if you bought the options you have an 80% of losing all your money and only a 20% of making a lot of money if held to expiry.