Option Profits Are Derived From Stock Price Movement

 Options (also known as derivatives) derive their value from the price of the underlying stock. Purchasing call options is bullish strategy as call options increase in value as the underlying stock increases in price.

A lot has been published about option strategies that invest in options based on whether an option is under valued or over valued according to the Black-Scholes Pricing Model. These option strategies are very complex and require high-level mathematical calculations to compute an option’s Alpha, Beta, Delta, Gamma, Theta etc. I never understood the logic of investing in an option because it was slightly under valued at the time of purchase. Under valued options can become more under valued. The price movement of the underlying stock determines an option’s value and the resulting profit/loss. When you purchase a call option your profits are determined by the price movement of the underlying stock. If we can select a stock moving up in price, purchasing a call option on that stock can produce enormous profits and will allow us to harness the tremendous leverage provided from option investing.

 There is a lot of investment advice available today on selecting stocks. I think in general investors suffer from ‘informational overload’ from the financial press. I’m sure you have watched many of the financial programs that are available on TV or read about investing on the internet. While these programs provide a valuable service, this information can be conflicting and confusing at times. One analyst recommends selling Google as the stock is overvalued and next analyst recommends buying Google which is cheap now compared to its future earnings potential. How does the average investor interpret this confusing advice and formulate a method for selecting stocks?

Don’t Select Stocks by Trying to Predict the Future

The problem with this type of advice is that it all comes down to trying to predict the future. The truth is that no one can consistently predict the future!  If someone could predict the future or had inside information about a ‘sure thing’ they would trade their own account and become wealthy. They certainly would not disclose this type of information to the public for free.

The best hope for the average investor to successfully select stocks is to play the game of percentages and probability. You want to put the odds in your favor by using a methodology that has a long history of success and does not rely on ‘guessing’ future price movement. Based on my trading experience, I prefer to use a combination of fundamental and technical analysis when selecting a stock. Let’s take a look at a recent call option purchase I made to illustrate my selection process.

Mastercard stock symbol MA is in a technical price uptrend with its 50-Day EMA above its 100-Day EMA. Twenty-four years of historical testing demonstrates that when a stock’s 50-Day EMA is above its 100-Day EMA the most likely future price movement for that stock is up. Mastercard also has sound fundamentals with an average annual intrinsic value growth rate of 79%. My historical data testing also demonstrates that there is a strong correlation between high rates of intrinsic value growth and future price appreciation. Mastercard has also been trading at new 52-Week highs with a MVP  Price Level confirmation making Mastercard a good candidate for a call option purchase.

My brokerage confirmation below shows that I purchased 10 of the Mastercard Jan 09 140-Strike calls at an average price of 78.04. These options expire in about 11 months. Mastercard stock was trading at 206.90 so the 140-Strike calls are in-the-money. These in-the-money calls have 11.14 points or 5.3% time value. Mastercard has to trade up to 218.04 in order for this trade to breakeven. My 12-10-07 blog explains my preference for buying in-the-money calls instead of out-of-the money calls.

The Call Option Purchase Analysis below shows that these in-the-money calls have 11.14 points or 5.3% time value. Mastercard stock has to trade up 5.3% to 218.04 in order for this trade to breakeven. My 12-10-07 blog explains my preference for buying in-the-money calls instead of out-of-the money calls. A 20% increase in MA stock to 248.28 would result in a 38.7% option return and a 30% increase in MA stock would result in a 65.3% return for the option.

Using a combination of technical and fundamental analysis to select stocks for call option purchases has worked well for me over the years. The sampling of Portfolio Statements below show recent call option purchases that have produced $496,044.03 in open trade profits with an average return of 86%. I use a money management system for my call option purchase strategy that will be a topic for one of my future blogs.