All about call options

I received an interesting e-mail recently from someone who wondered whether buying call options instead of the stocks recommended in my Internet Wealth Builder newsletter is a good strategy, especially for the higher-priced issues. He wrote:

“Some of your recommendations (e.g. Alcan, EnCana, Petro-Canada) are too high-priced for novice investors to purchase a reasonable number of shares. In these cases, does it make sense for these investors to instead purchase call options on your recommended stocks? Commissions are higher, but the option premium is much less than the stock price.” – M.T.

Let’s take a look at this approach, but first some background for those who are not familiar with call options and how they work.

Call options allow you to buy a stock at a certain price (the “strike price”) up to a specific date. You do not own anything except that right, which you would only exercise if the shares rise to the strike price. However, if the underlying share price rises between the time of the option purchase and the expiry date, the market value of the option itself will rise as well and you can make a capital gain by selling. So your upside can significant, while the downside is limited to the price you pay for the option – which, of course, can mean a 100 per cent loss.

Each option gives you the right to buy 100 shares of the underlying stock at the strike price. Let’s look at a real world example. On Wednesday, March 17 the closing price on Alcan April $60 call options on the Montreal Stock Exchange (trading symbol AL.DL) was $1.70. So you would have paid $170 plus commission for the right to buy 100 Alcan shares at that price before the options expire. That occurs on the Saturday after the third Friday of the contract month so this Alcan option will expire on April 17.

Alcan stock closed on March 17 at $59.10. So it was trading at the time at just below the strike price, hence the high premium. If the shares rise to above $60, the options are said to be “in the money” and their market price will increase. At that point, you can choose to exercise them, sell for a profit, or hang on in hopes that the stock will move even higher, thereby increasing your capital gain on the option. Of course, if the share price of Alcan falls so will the price of the options. And remember, if you don’t sell them or exercise them before the expiry date, they become worthless.

Options are really a leveraged play on the short-term movements of a stock. Your profit or loss will be disproportionately affected by the changes in the share price. To illustrate this, look at what happened on Thursday, March 18. The price of Alcan shares dropped $1 to close at $58.10. That was a loss of 1.7 per cent. By contrast, the closing price of the $60 option fell by 35c to $1.30, a decline of just over 20 per cent. Owners of the stock took a small hit but options investors got clobbered!

My stock recommendations are usually longer-term in nature so I do not see call options as an appropriate alternative to owning the shares themselves. I have confidence in the long-term prospects of the companies we pick for our newsletters. But short-term market volatility is unpredictable. If Alcan shares don’t bounce back in the next four weeks, anyone who bought the April $60 options at $1.70 will suffer a big loss. Shareholders, on the other hand, can wait out any temporarily slump in the price and collect their dividends in the meantime.

If you cannot afford to buy a board lot (100 shares) of a recommended stock, consider putting in an order for a lesser quantity, say 25 shares. Brokers used to charge hefty premiums for so-called “odd lots” but that is not the case any longer. However, if the order is too small, the minimum commission charged by the broker may be disproportionately high.

If you want to learn more about options trading, the Montreal Stock Exchange offers an in-depth booklet with all the details. You can download it at

Adapted from an article that originally appeared in the Internet Wealth Builder.