When you buy calls, you can control stocks for less than their current price, but still give you the full appreciation. Imagine gaining 20% appreciation, but only paying 50% – 70% of the full price…
How? It’s kinda like being the tenant buyer in a rent-to-own deal. The lease option agreement is like the call option contract, giving you the right to buy that house at a specific price in 2 or 3 years.
It’s still confusing, I know, so let’s dive in.
So how is buying calls like being a tenant buyer?
Let’s look at an example:
You have $20,000 saved up to buy a home, but the average price for houses in your area is $600,000. You don’t have enough for a down payment on a home and you don’t qualify for a mortgage.
So you partner with a real estate investor who buys the house for you and you rent the house from them.
You agree on a price that you will purchase the house for in 2 or 3 years. Then you pay the investor $20,000 up front. This will be credited towards your down payment for the house.
Because of your “Lease Option Agreement” with the investor, you now control a $600,000 asset, but only paid $20,000, plus rent each month.
Buying calls is a similar concept…
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Buy calls cheap, but earn full profit
Technically what we’re talking about here are deep-in-the-money (DITM) calls. Don’t worry too much about the name for now.
Deep-in-the-money calls are stock option contracts.
Stock options are promises to buy or sell 100 shares of a stock by a specified date if the stock price hits a specified price. If you’re buying that promise, you pay a premium up front.
We talk a lot more about what options are and the different types of options in our Options for Beginners Series. You can get acquainted with the basics there if you need to.
Options for Beginners talks mostly about selling options. In this case, though, we are BUYING options, specifically “call” contracts.
We are buying the right to buy someone’s shares at a specified price by a specified date. For that right, we pay the option seller a premium up front.
Let’s say you like a company and you think it’s a good time to invest in them. But maybe you don’t have a lot of cash ready, or you just don’t feel like paying full price for the shares.
So instead of buying shares outright, buy a call contract instead.
Just like the lease option agreement, we now have an agreement to buy an asset at a future time for a specific price, and we’re paying a smaller premium up front.
How DITM calls work
What makes a DITM call special is that you now have control of 100 shares of the company, but you only paid the premium for the call contract, you haven’t actually paid for the shares.
Option contracts are traded on the stock market just like stocks. People and organizations buy and sell millions of them each day. It’s an active market. That means the value of your call contract can rise and fall.
When you buy a call far enough into the future, at a low enough strike price, it will actually follow the price movement of the stock price fairly closely.
So if the stock price rises 20%, the contract can rise 18% – 20% as well (it’s not a perfect match).
If your option contract is up 20%, you can sell it back to the market and keep the profit.
So why buy calls instead of stocks?
If you do it right, you’re only spending 50% – 70% of the stock’s current price to buy the call.
This can be a more efficient use of your cash, which is attractive in Register Accounts. It can also let you control more expensive or volatile stocks without having to buy shares outright.
One other unique feature of DITM calls is that they decrease in value slower than they increase. There’s a technical explanation for this that we won’t dig into here. But when played right, DITM calls can shield you from price dips. Unless the stock tanks. There’s no protecting against sudden movements like that.
So what do I do with this information?
This could be particularly useful in your registered accounts (TFSA, RRSP, etc.). You just have to be mindful of the expiry dates. You don’t want to buy calls then forget about them. They will expire and you’ll be left with nothing.
The point here is to buy low and sell high before the expiry date hits.
If you’re curious about other ways options can give you a leg up in the stock market, I recommend you start with our Options for Beginners series. It’s designed to set you up with the basics so you can launch into your own stock hacking journey.
That’s all for now.
Your fellow Stock Hackers,
🍒Cherry & Erwin
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