February 24, 2003

Call Writing and Call Buying Compared
By John Brasher, CallWriter Publisher

The differences between call writing and call buying may seem obvious, but a number of our readers have asked for more information. And truthfully, some of the differences are subtle. The option books all say that call buying usually is not a good strategy, so what's the straight skinny? Well, read on and decide for yourself.

To buy or not to buy...

Remember first of all that options are derivative securities, not equities. An option has a fixed life and ceases to exist on its expiration date, whereas stock never expires. Plus, a company only has a particular number of shares outstanding at any one time, but there is no limit on the number of puts and calls that can be written on a company's stock. When you write (sell) a call, you are short that call, and when you buy a call, you are said to be long the call. Now, let's do some analysis.

How Long and Short Calls Win.  A stock can do three things before the call expires: decline, not move significantly, or advance. How do the call writer and call buyer win? The call WRITER makes money if the stock advances, holds price or declines only slightly and only loses money if the stock drops more than the amount of the premium he received for writing the call. The call BUYER loses money unless the stock advances enough (before expiration) to make the long call win, period. So anything other than a significant price advance leaves the long call high and dry. To win consistently on long calls, you have to be an excellent stock picker, and this market is tough for stock picking. Which odds do you like better?

Income vs. Cost.  The amount that is paid to buy an option is known as the premium. When you write a call, the premium goes into your pocket. But when you buy a call, you have to pay the premium. Putting money in your pocket is better than incurring a debit, in our humble opinion.

Time.  Time works against the call buyer, and stocks don't move up enough (except during rallies) to get a profit out of most long calls. The problem on long calls is that: 1) the stock has to move up enough to make the call profitable, 2) before the call expires. On the other hand, time is the call writer's friend, because expiration locks in his return and frees up the stock so that more calls can be written against it.

Market Timing.  Long calls only work reliably in bull markets or during strong bear rallies, and it is a fact that even when the bull is running, the vast majority of call buyers lose.

Naked Puts Make More Sense Than Long Calls.  If you are good at picking stocks that advance or hold price, then why buy call options? Instead, write NAKED PUTS on the stocks you pick, which "puts" premium money into your jeans right away. Even with a Level 1 or Level 2 account, many brokerage firms will let you write naked puts. Better yet, (1) naked puts don't require that you tie up capital buying the stock, and (2) the margin requirement usually is only about 20% of the stock price, unlike naked calls, where the margin requirement will be 50%-100%.

Are we knocking call buying or call buyers? No! Thank God they're out there. And don't get the idea that most call buyers are starry-eyed dreamers, since many of them are buying calls as part of a hedge position. Nevertheless, it is a fact that approximately 80% of calls expire worthless. This means that 80% of call buyers get hosed. If you consistently make money buying calls, I want your telephone number! We think that buying calls is a poor way to speculate. The consistent money is in writing calls, not buying them. That's we established CallWriter.com, not callbuyer.com!

Good luck and good trading!