Option trading long calls

Going Long On Calls.

As your knowledge of puts and calls grows, you will want to consider trading strategies that can be used to make money in the options market. One of these is buying call options and then selling or exercising them to earn a profit.

Covering a call is the act of selling calls to someone in the market in exchange for the option premium. When you're buying a call, you will be paying the option premium in exchange for the right (but not the obligation) to buy shares at a fixed price by a certain expiry date. (If you need to brush up on the basics of option trading, please see the Options Basics Tutorial .)

[Covered calls are a great way to generate an income from options, but there are countless other strategies that investors may want to consider. Investopedia's Options for Beginners Course will teach you how options work and show you basic and advanced strategies to put them to work. With over five hours of on-demand video, exercises, and interactive content, you'll learn everything from calculating breakeven points to exploring advanced concepts like straddles and spreads.]

Trading Calls: Is It My Calling?

The popular misconception that over 90% of all options expire worthless frightens a lot of investors. They believe this incorrect statistic and then conclude that, if they buy options, they will lose money 90% of the time! This is completely false. In fact, according to the CBOE, about 30% of options expire worthless, while 10% are exercised and the other 60% are traded out or closed by creating an offsetting position.

The focus of this article is the technique of buying calls and then selling them or exercising them for a profit. We will not consider selling calls and then buying them back at a cheaper price - this is called naked call writing and is a more advanced topic. (To learn more, read Naked Call Writing or To Limit Or Go Naked, That Is The Question .).

In this article the term "trading calls" means first buying a call and then closing out the position later - such a strategy is called "going long" on a call. (To learn more about making money going long on a put, see Prices Plunging? Buy A Put! )

The basic reason for buying calls is that you are bullish on a stock. Why couldn't you just buy the stock and not worry about options? After all, stocks never expire - you could hold onto a stock forever - whereas options do. So, why consider an investment that has an expiry date? The reason is simple: leverage.

Consider the following example: XYZ stock trades for $50. The XYZ $50 call that expires in a month trades for $3. Would you like to buy 100 shares of XYZ for $5,000 or buy one call option for $300 ($3 x 100 shares)? One important thing to consider is that payoffs depend on closing prices a month from today. (The example deals with a one-month option, but you can have options that last for different lengths of time. LEAPS, for instance, expire more than a year away.) Let's look at a graphic illustration of your choice:

As you can see from the graph, the payoffs for each investment are different. While buying the stock would require an investment of $5,000, you could, with an option, control an equal number of shares for only $300. You'll also note that the break-even point on the stock trade is $50 per share, while the break-even on the option trade is $53 per share (ignoring all commissions).

The key point, however, is that while both investments have unlimited upside within the next month, the losses on the options are capped at $300, while the potential losses on the stock could go all the way to $5,000. Remember that buying a call option gives you the right but not the obligation to buy the stock, so your maximum losses are the premiums you paid.

Closing Out The Position.

You can close out your call position by selling the call back into the market or by having the calls exercised, in which case you would have to deliver cash to the person who sold you the call. Say that in our example, the stock was at $55 near expiry. You could sell your call for approximately $500 ($5 x 100 shares), which would give you a net profit of $200 ($500 minus the $300 premium). Alternatively, you could have the calls exercised, in which case you would have to pay $5,000 ($50 x 100 shares), and the person who sold you the call would deliver the shares. With this approach, your profit would also be $200 ($5,500 - $5,000 - $300 = $200). Note that the payoff from exercising or selling the call is identical: a net of $200.

Trading calls can be a great way to increase your exposure to a certain stock without tying up a lot of funds. Because options allow you to control a large amount of shares with relatively little capital, they are used extensively by mutual funds and large investors. As you can see, trading calls can be used effectively to enhance the returns of a stock portfolio.

Long Call Trading Strategy.

The long call, or buying call options, is about as simple as options trading strategy gets, because there is only one transaction involved. It's a fabulous strategy for beginners to get started with and is also commonly used by more experienced traders too.

It enables you to make potentially unlimited profits through the power of leverage, while limiting your potential losses at the same time. It comes highly recommended if you are expecting a significant rise in the price of any asset that has options contracts traded on it, although it has other purposes too.

Key Points.

Bullish Strategy Suitable for Beginners One Transaction (buy calls)li Net Debit (upfront cost involved) Also known as Buying Call Options Low Trading Level Required.

When to Use the Long Call.

The primary use of the long call is when your outlook is bullish, meaning you expect a security to go up in value. It's best used when you expect the security to increase significantly in price in a relatively short period of time. Although there are still benefits to using it if you believe the security will rise more slowly over time. You just need to be aware of the effects of time decay, because the time value of calls will depreciate over time.

Generally speaking, any time you have a bullish outlook on a security you could consider using the long call. However, there are probably better alternatives if you are only anticipating that the price of the security will increase a little.

Why Use the Long Call.

This is a good strategy to use for a number of reasons. For one thing it's really simple, so the calculations involved are quite straightforward. It's essentially an alternative to buying an asset that you expect to increase in value, but because of the leverage power that options have you can make a greater return on your investment.

The downside risk is lower than investing directly in an asset, because the most you can lose is the cost of the calls that you buy. No matter how much the underlying security drops in value this is true. It's also flexible, as you can effectively select the risk to reward ratio of the trade by choosing the strike price of the options contracts you buy.

How to Use the Long Call.

As we have mentioned, this is an incredibly straightforward strategy. The only transaction involved is using the buy to open order to purchase calls on the security that you believe is going to increase in price. You can buy either American style or European style contracts, depending on whether you want the flexibility of being able to exercise at any time or not. That flexibility does come at a cost, though, as American style contracts are typically more expensive than the European style equivalent.

There are other specific decisions that you need to make too; what expiration date to use and what strike price are two examples. If you are expecting the underlying security to quickly rise in price, then buying contracts with a short time until expiration makes sense. If you think the underlying security will take longer to rise, then you will need to buy longer term contracts. Longer term contracts will usually cost a little more, because they will have more time premium associated with them.

What strike price to use takes a little more consideration, although we would generally recommend that beginner traders just buy contracts that are at the money, or very near to the money.

For the more experienced traders, you may like to compare the delta values of options with different strike prices, and determine which strike price to use based on the returns that you are looking to make and exactly what you expect to happen to the price of the underlying security.

For example, if you were expecting a sharp increase in the price then buying cheaper out of the money contracts may enable you to maximize your returns. If you were expecting a more moderate increase in the price, then buying in the money contracts with a higher delta value may be the better choice. There is not particularly a right or wrong approach to making this decision; it ultimately comes down to your own expectations and what you are hoping to achieve from the trade.

How the Long Call Profits.

The relevant underlying security simply needs to increase in price sufficiently. Broadly speaking, the more the underlying security increases in price, the more profit this strategy will generate. There are two ways that you can realize any profit that this strategy makes: either by selling the calls when they have gone up in price, or by exercising them to buy the underlying security at the strike price, and then selling it at the current trading price.

Selling the calls is a more common choice for most traders, but there may well be circumstances when buying the underlying security is a better solution.

The maximum loss of this strategy is limited to the amount of the net debit you have to pay when implementing it. The worse-case scenario is that the contracts purchased expire worthless when the underlying security fails to move above the strike price. It's also possible to lose money if the underlying security does increase in price, but not by enough to cover the cost of the contracts and/or the effect of time decay.

Advantages & Disadvantages.

There are many advantages of this strategy, and not too much in the way of disadvantages. Arguably the biggest advantage is the fact that it's possible to profit from the underlying security increasing in price while limiting losses if it falls. The inherent leverage offered by calls also means that it's possible to make profits comparable to actually owning the underlying security, but without having to invest as much capital.

This makes it an ideal strategy for traders that don’t have a huge amount of money to trade with. Alternatively, if you do have plenty of capital to invest, you could potentially make much bigger returns than you could by investing the same amount directly in the underlying security.

The simplicity is also a big advantage, particularly for beginners. It's easier to calculate the potential profits than it is with some of the more complex strategies, and less transactions means paying less in commissions. There's also no margin required and you know exactly what your maximum loss is at the start. It's also easy to make further transactions and convert the strategy into an alternative one should your outlook change.

The main disadvantage is that you have no protection against the underlying stock falling in value. You run the risk of losing everything you invested in the strategy if the calls you bought expire out of the money. You are also exposed to the effects of time decay, because the extrinsic value of calls is negatively affected as time passes.

Here we have provided an example of the long call strategy, showing how it would be used and a few potential outcomes at the point of expiration. Please be aware this example is purely to provide a rough overview of how it can work and it doesn't necessarily use exact prices. For the purposes of this example we have ignored the commission costs,

Company X stock is trading at $50, and you expect it to increase in value. At the money calls on Company X stock (strike price $50) are trading at $2. You purchase 1 call contract (one contract covers 100 options) for an investment of $200.

If Company X stock increases to $52 by expiration.

Your contracts will be worth roughly what you paid for them and you will break even on the trade at expiry. You could exercise them to buy 100 shares at $50 each and either sell them for a profit or hold on to them if you felt they would increase further in price. Alternatively you could sell the contracts just before expiration.

If Company X stock increases to $55 by expiration.

Your contracts will be worth roughly $500 and taking into account your initial investment of $200, you will have made a profit of around $300. You could either exercise them or sell them just before expiration for a profit.

If Company X Stock falls or does not increase by expiration.

Your contracts would expire worthless, and you would lose your initial investment.

Remember, you don't have to hold your options all the way until expiration. Their price will increase as the price of Company X stock increases, so you can sell them for a profit at any point if you choose. Equally, if the price of Company X stock is falling or staying stable, then you could sell them to recover any remaining extrinsic value and reduce your potential losses.

Profit, Loss & Break-Even Calculations.

Maximum profit is unlimited. Profit is made when “Price of Underlying Security > (Strike Price + Price of Option)” Profit per option owned is “Price of Underlying Security – (Strike Price + Price Of Option)” Maximum loss is limited Maximum loss is made when “Price of Underlying Security < or = Strike Price” Maximum loss per option owned is “Price of Option” Break-even point is when “Price of Underlying Security = (Strike Price + Price of Option)”.

This is a simple strategy that is ideal to use when you are expecting a security to increase in price significantly and quickly. It's very simple and well suited to beginners; it's a great way to get started with options trading.

The potential profits are theoretically unlimited, and yet the potential losses are limited to the money invested in the calls when making the trade.

Long Call.

The Strategy.

A long call gives you the right to buy the underlying stock at strike price A.

Calls may be used as an alternative to buying stock outright. You can profit if the stock rises, without taking on all of the downside risk that would result from owning the stock. It is also possible to gain leverage over a greater number of shares than you could afford to buy outright because calls are always less expensive than the stock itself.

But be careful, especially with short-term out-of-the-money calls. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment, whereas if you own the stock it will usually still be worth something. (Except for certain banking stocks that shall remain nameless.)

Options Guy's Tips.

Don’t go overboard with the leverage you can get when buying calls. A general rule of thumb is this: If you’re used to buying 100 shares of stock per trade, buy one option contract (1 contract = 100 shares). If you’re comfortable buying 200 shares, buy two option contracts, and so on.

If you do purchase a call, you may wish to consider buying the contract in-the-money, since it’s likely to have a larger delta (that is, changes in the option’s value will correspond more closely with any change in the stock price). You can learn more about delta in Meet the Greeks. Try looking for a delta of .80 or greater if possible. In-the-money options are more expensive because they have intrinsic value, but you get what you pay for.

Buy a call, strike price A Generally, the stock price will be at or above strike A.

Who Should Run It.

Veterans and higher.

NOTE: Many rookies begin trading options by purchasing out-of-the-money short-term calls. That’s because they tend to be cheap, and you can buy a lot of them. However, they’re probably not the best way to get your feet wet. The Rookie’s Corner suggests other plays more suited to beginning options traders.

When to Run It.

You’re bullish as a matador.

Break-even at Expiration.

Strike A plus the cost of the call.

The Sweet Spot.

The stock goes through the roof.

Maximum Potential Profit.

There’s a theoretically unlimited profit potential, if the stock goes to infinity. (Please note: We’ve never seen a stock go to infinity. Sorry.)

Maximum Potential Loss.

Risk is limited to the premium paid for the call option.

Ally Invest Margin Requirement.

After the trade is paid for, no additional margin is required.

As Time Goes By.

For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.

Implied Volatility.

After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction (but you’ll hope the direction is up).

Check your strategy with Ally Invest tools.

Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks. Remember: if out-of-the-money options are cheap, they’re usually cheap for a reason. Use the Probability Calculator to help you form an opinion on your option’s chances of expiring in-the-money. Use the Technical Analysis Tool to look for bullish indicators.

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Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

Multiple leg options strategies involve additional risks, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct.

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Long Call.

The long call option strategy is the most basic option trading strategy whereby the options trader buy call options with the belief that the price of the underlying security will rise significantly beyond the strike price before the option expiration date.

Compared to buying the underlying shares outright, the call option buyer is able to gain leverage since the lower priced calls appreciate in value faster percentagewise for every point rise in the price of the underlying stock.

However, call options have a limited lifespan. If the underlying stock price does not move above the strike price before the option expiration date, the call option will expire worthless.

Unlimited Profit Potential.

Since they can be no limit as to how high the stock price can be at expiration date, there is no limit to the maximum profit possible when implementing the long call option strategy.

The formula for calculating profit is given below:

Maximum Profit = Unlimited Profit Achieved When Price of Underlying >= Strike Price of Long Call + Premium Paid Profit = Price of Underlying - Strike Price of Long Call - Premium Paid.

Limited Risk.

Risk for the long call options strategy is limited to the price paid for the call option no matter how low the stock price is trading on expiration date.

The formula for calculating maximum loss is given below:

Max Loss = Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying The Options Guide.

Bullish Strategies.

Options Strategies.

Options Strategy Finder.

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