Long Call Explained

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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.

Long Call Construction
Buy 1 ATM Call

Leverage

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

Breakeven Point(s)

The underlier price at which break-even is achieved for the long call position can be calculated using the following formula.

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  • Breakeven Point = Strike Price of Long Call + Premium Paid

Example

Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You believe that XYZ stock will rise sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ call option covering 100 shares.

Say you were proven right and the price of XYZ stock rallies to $50 on option expiration date. With underlying stock price at $50, if you were to exercise your call option, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000. Since you had paid $200 to purchase the call option, your net profit for the entire trade is therefore $800.

However, if you were wrong in your assessement and the stock price had instead dived to $30, your call option will expire worthless and your total loss will be the $200 that you paid to purchase the option.

Note: While we have covered the use of this strategy with reference to stock options, the long call is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the long call in that they are also bullish strategies that have unlimited profit potential and limited risk.

Beginner’s Guide to Call Buying

The popular misconception that 90% of all options expire worthless frightens investors into mistakenly believing that if they buy options, they’ll lose money 90% of the time. But in actuality, the Chicago Board Options Exchange (CBOE) estimates that only about 30% of options expire worthless, while 10% are exercised, and the remaining 60% are traded out or closed by creating an offsetting position.

Key Takeaways

  • Buying calls and then selling or exercising them for a profit can be an excellent way to bolster your portfolio’s overall performance.
  • Investors most often buy calls when they are bullish on a stock or other security because it affords them leverage.
  • Call options dramatically reduce the maximum loss potential an investment may incur, unlike stocks, in which the entire value of the investment may be lost, should the share price dip to zero.

Call Buying Strategy

When you buy a call, you pay the option premium in exchange for the right to buy shares at a fixed price by a certain expiration date. Investors most often buy calls when they are bullish on a stock or other security because it affords them leverage.

Consider the following example: let’s assume that XYZ stock trades for $50. Let us further assume that a one-month call option on the stock costs $3. This presents a choice: would you rather buy 100 shares of XYZ for $5,000 or would you rather buy one call option for $300 ($3 x 100 shares), considering the payoff depends on closing prices one month from now? Still confused? Consider the following graphic illustration of the two different approaches:

As you can see, the payoff for each investment is different. While buying the stock will require an investment of $5,000, you can control an equal number of shares for just $300 by buying a call option. Also note that the breakeven price on the stock trade is $50 per share, while the breakeven price on the option trade is $53 per share (not factoring in commissions or fees).

While both investments have unlimited upside potential in the month following their purchase, the potential loss scenarios are vastly different. Case in point: while the biggest potential loss on the option is $300, the loss on the stock purchase can be the entire $5,000 initial investment, should the share price plummet to zero.

Closing the Position

Investors may close out their call positions by selling them back to the market or by having them exercised, in which case they must deliver cash to the counterparties who sold them. Continuing with our example, let’s assume that the stock was trading at $55 near the one-month expiration. Under this set of circumstances, 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 call exercised, in which case you would be compelled to pay $5,000 ($50 x 100 shares) and the counterparty who sold you the call would deliver the shares. With this approach, the profit would also be $200 ($5,500 – $5,000 – $300 = $200). Note that the payoff from exercising or selling the call is an identical net profit of $200.

The Bottom Line

Trading calls can be an effective way of increasing exposure to stocks or other securities, without tying up a lot of funds. Such calls are used extensively by funds and large investors, allowing both to control large amounts of shares with relatively little capital.

Long Position vs. Short Position: What’s the Difference?

Long Position vs. Short Position: What’s the Difference?

When speaking of stocks and options, analysts and market makers often refer to an investor having long positions or short positions. While long and short in financial matters can refer to several things, in this context, rather than a reference to length, long positions and short positions are a reference to what an investor owns and stocks an investor needs to own.

Understanding a Long Position vs. a Short Position

Long Position

If an investor has long positions, it means that the investor has bought and owns those shares of stocks. By contrast, if the investor has short positions, it means that the investor owes those stocks to someone, but does not actually own them yet.

For instance, an investor who owns 100 shares of Tesla (TSLA) stock in his portfolio is said to be long 100 shares. This investor has paid in full the cost of owning the shares.

Key Takeaways

  • With stocks, a long position means an investor has bought and owns shares of stock.
  • On the flip side of the same equation, an investor with a short position owes stock to another person but has not actually bought them yet.
  • With options, buying or holding a call or put option is a long position; the investor owns the right to buy or sell to the writing investor at a certain price.
  • Conversely, selling or writing a call or put option is a short position; the writer must sell to or buy from the long position holder or buyer of the option.

Short Position

Continuing the example, an investor who has sold 100 shares of TSLA without yet owning those shares is said to be short 100 shares. The short investor owes 100 shares at settlement and must fulfill the obligation by purchasing the shares in the market to deliver.

Oftentimes, the short investor borrows the shares from a brokerage firm in a margin account to make the delivery. Then, with hopes the stock price will fall, the investor buys the shares at a lower price to pay back the dealer who loaned them. If the price doesn’t fall and keeps going up, the short seller may be subject to a margin call from his broker.

A margin call occurs when an investor’s account value falls below the broker’s required minimum value. The call is for the investor to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin.

Key Differences

When an investor uses options contracts in an account, long and short positions have slightly different meanings. Buying or holding a call or put option is a long position because the investor owns the right to buy or sell the security to the writing investor at a specified price.

Selling or writing a call or put option is just the opposite and is a short position because the writer is obligated to sell the shares to or buy the shares from the long position holder, or buyer of the option.

For example, an individual buys (goes long) one Tesla (TSLA) call option from a call writer for $28.70 (the writer is short the call). The strike price on the option is $275 if TSLA trades for $303.70 on the market.

The writer gets to keep the premium payment of $28.70 but is obligated to sell TSLA at $275 if the buyer decides to exercise the contract at any time before it expires. The call buyer who is long has the right to buy the shares at $275 at expiration from the writer if the market value of TSLA is greater than $275 + $28.70 = $303.70.

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