There are many ways to make profit from a stock’s movement beyond putting your money in the actual stock itself with a popular one being the long call option strategy.
Options provide a seemingly endless array of strategies because of the countless ways traders can combine buying and selling call options and put options at different expirations and strike prices.
An option is a financial contract that allows (but doesn’t require) an individual to buy or sell an underlying security like a stock, index or exchange-traded fund (ETF) at a specified price (strike price) within a given period, usually a few weeks or months.
Buying an option that gives you the right to buy shares at a later time is called a “call option,” whereas buying an option that gives you the right to sell shares at a later time is called a “put option.”
Buying and selling options is done on the options market, which trades contracts based on securities. You can buy call options through a brokerage firm, like Robinhood, TD Ameritrade or Fidelity.
One of the most common positions that a trader can take is a long call.
This article will explain what it means to be long a call option and how to use long call strategies to generate a profit.
What is a long call option?
A long call is simply a call option that is betting that the underlying stock is going to increase in value prior to its expiration date.
If you are buying a long call option, it means you want the price of the stock (or other security) to go up so that you can generate profit from your contract by exercising your right to buy that stock (and usually immediately sell them to rake in the profit).
To be “long a call option” means you bought calls on a specific stock. The seller of the calls has a short position in the options.
As one of the most common options trading strategies, a long call is a bullish strategy. You would buy a call option if you think that the price of the stock is going to go up, since the value of a call increases if the underlying stock price increases.
For example, let’s assume stock ABC has a price per share of $20.
A trader buys one call option for ABC with a strike price of $25 expiring in one month. He expects the stock price to rise above $25 in the next month.
Assume the premium for the call option costs $1 per share.
As the holder of the option, the trader has the right to buy 100 shares of ABC at a price of $25 until the expiration date. One option contract is equal to 100 shares of the underlying stock.
Assume the price of ABC rises to $40 in that month. Now, the buyer can exercise the call option and buy 100 shares of stock at $25, rather than $40. Once the option buyer buys the shares at $25, he can immediately sell them at the market price of $40.
This generates a profit of $15 per share for the buyer. The gains would exactly offset the $1 upfront premium paid.
The breakeven on a long call is the strike price plus the premium.
- Breakeven point = strike price of long call + premium paid
Profit and loss potential
Any time that you buy an option, the maximum that you can lose is the premium plus the commissions that you paid for the option This happens if the option is “out of the money” upon expiration, in which case it is worthless.
Maximum loss occurs when price of the underlying stock is less than or equal to the strike price of long call. You can calculate maximum loss using the following formula:
- Maximum loss = premium paid + commissions paid
- Maximum loss occurs when price of underlying <= strike price of long call
In above example, since the premium for the call option costs $1 per share, the maximum amount the buyer can lose is the $100 he will pay for the option to the option writer.
Keep in mind that option contracts have expiration dates. This means that a contract must be exercised before or on the expiration date. If you fail to exercise the contract, then it will expire with no value.
For example, if the share price of ABC never rises above the strike price of $25, then the call option expires, and the buyer is at a loss of $100 because of the premium.
There is no theoretical upper-bound limit to stock prices, so the maximum gain is potentially unlimited.
Of course, stock prices don’t increase to infinity in reality, so this gain is purely hypothetical.
In this example, if the stock was acquired by another company for $150 per share, you would enjoy substantial gains of $129.
Difference between buying in- and out-of-the-money calls
In-the-money (ITM) and out-of-the-money (OTM) are phrases that are used to differentiate how close an option’s strike price is to the security’s current price.
Most of the open interest on a security is often in-the-money, and out-of-the money options tend to be relatively cheap or expensive compared to the cluster of option prices that are in the money.
Going long on out-of-the-money calls can cheaper though call options have a higher chance of expiring valueless. In-the-money calls are relatively expensive than out-of-the-money calls but less amount is paid for the time value of the option.
Call options are one of the most exciting and lucrative areas of contemporary finance.
They can be used to achieve profits that are oftentimes your initial investment and also create sophisticated and highly complex positions that would not be possible with traditional securities.
Call options buyers can also capture all the upside of given shares for just a small percentage of the share price.
However, call option traders can also get burned. One common path to losses is selling unhedged calls that blow up when a stock makes sharp movement the wrong way.
Essentially, a long call option strategy should be used when you are bullish on a stock and believe the price of the shares will increase before the expiration date of the contract.