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Three Steps to Successful Call Buying

Tom Gentile

With earnings season hitting its peak, the volatility index on the way down and October out of the way, the probability for this market to move higher is very good.

Currency markets have bounced off their lows, oil has backed off its highs and with the exception of certain volatile sectors, the markets are starting to move normally again. At the end of October, traders like both to reflect and to make excuses for why the market dropped and why it's likely to head higher. While it's nice to understand the why, as a trader, I'm more interested in the number of occurrences and the likelihood that the past will help me get an idea of the future.

Since the early 1930s, the market has had a better-than 85% tendency for the markets to be higher on Dec. 31 than they were just two months earlier. Why does this happen? Some say the selling that occurs each fall is overdone, and therefore buying must balance out the shorts.

Others say that the majority of institutions and hedge funds close their books out on Oct. 15, so managers are unloading stocks before that deadline and buying shortly thereafter. Whatever the tendency may be, the historian trader is more interested in using this information for the future.

If this month is any indication of last October, we are due for a nice rally. Looking at stocks that should lead the way, the stronger stocks in sectors such as computer technology, health care and semiconductor indices should lead the way. Stocks such as Sun Microsystems (SUNW Quote), Seagate (SEG Quote) and Wellpoint (WLP Quote) are all strong stocks in strong sectors. Naturally, it's better to be a buyer of strong stocks in the strong sector than weak stocks.

These stocks are the cream of the crop, and they're poised to move much higher in a year-end rally. Let's say we're interested in Sun. Looking at the chart, you can see that the stock is outpacing the Nasdaq Composite Index for the year, is above its 200-day moving average and the fundamentals are bright.

Rising Sun? Sun Has Been Outpacing the Nasdaq Comp

Which call options should I buy, and when should I sell? When first thinking about it, it seems simple enough; but when you are looking at options strikes and months, your one or two ideas turn into hundreds of possibilities. At this point, most people new to options trading aren't thinking of exits. Here are a few things I have learned over several years of experience.

Don't get fooled into buying call options right before an earnings announcement. That's the worst time to buy an option, as the demand for option premium increases to a peak, only to be crushed after the earnings have been released. Options are best bought several weeks before any scheduled announcements when the premiums are low. Also, no matter how much you love the company you work for, it's best to look at several stocks in different market sectors. As we traders say, it's better to be married to your spouse than to a stock.

Don't get tempted into buying short-term call options on a long-term stock. Even though they are cheaper, you have less time to be right on the perception of the stock you are playing.

Don't spend time thinking about profits you don't already have. Also remember that options that are in-the-money have more real value and therefore have a greater chance of being worth something as expiration draws near. Out-of-the-money options, even though they are the cheapest, have the lowest chance of being worth something at expiration.

Do spread your risk. The most ignorant thing any trader can do is put all of his money into one trade. This can cost you a trading career. It's better to spread your risk and start off small until you get more familiar with the options you are trading, as well as the behavior of the underlying asset.

Another way to spread your risk is by carefully choosing each strategy. Using a simple call spread can drastically reduce your risk, while giving you a better breakeven on the position to expiration. Educate yourself by learning about the full range of options strategies so you have the right tools for the stock in question.

Do have an exit plan. It is said that in house fires, the cause of death is usually not the fire but the lack of an exit plan; trading is no different. Before putting on any trade, you should always have a profit and loss plan.

The most important thing to remember is that call buying is a three-part process. The first part is determining the direction of the stock. Next, you have to determine the time it is going to take for the stock in question to get to an assumed price. Finally, you have to determine if the trade is worth the cost. Following these steps can give you a better chance of long-term consistency and success in the options markets.