Introduction To Long Call Options Strategy
The long call strategy involves buying a call option in order to profit from upside moves to the underlying security. When the price of the underlying security moves up above the the strike(exercise) price of the call option before the expiration date of the option, the option is said to be in the money. In the money call options are worth more than at the money or out of the money call options. In general, when the price of the underlying security increases, the option premium (price) of the call option increases as well. The trader with a long call could sell to close the position for a profit.
If the price of the underlying security does not trade above the strike(exercise) price of the call option contract when the option expires, the option will expire worthless.
Out of the money calls vs in the money calls
In the money calls will cost more than out of the money calls as it has a greater time value. However, purchasing out of the money calls will have a higher probability of expiring worthless.
Margin requirement
There is no margin requirement for option traders who long calls as the risk is perceived by brokers to be a limited one. To be exact, the maximum loss that a buyer of a call option can incur is the premium(net debit) paid for the option. If the option expires worthless by expiration date, the option is worth $0 and the call buyer loses the entire option premium.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook : Very Bullish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss
Step 7 : Loss calculation
Step 8 : Potential for unlimited profits
Step 9 : Calculation of profits
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a long call
Step 12 : Exit Trade
Step 13 : Calculating the return on investment for a call option or the percentage profit/loss
Step 14 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Before using a long call strategy, an options trader will need to perform economic analysis, fundamental analysis and technical analysis. The broad market direction must be an uptrend and the price of the underlying security must be worth more than it is currently. Lastly, technical analysis will determine the entry point. Some chart patterns traders should look out for is :
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 :Outlook : Very Bullish
The trader that places a long call trade is bullish on the price of the underlying security and projects that the underlying security will make a price move to the upside within the remaining life of the option, that is, between the time the call option is bought till the time it expires worthless. More importantly, the trader is also projecting that the price of the underlying security will move up above the breakeven point such that he will profit from the trade. A long call strategy is a very bullish strategy. For example, 2 companies trade at $30 per share currently. Company A is projected to rise to $33 while Company B is projected to rise to $50 within the same span of time. The options trader should use a long call on instances where he finds Company B. In other words, Company B is a better candidate for a long call position than Company A.
Step 3 :Study the option chain
Next, the options trader should study the option chain and select the option contract that he wants to buy. Do bear in mind that options are subject to time decay. Also, the options trader should consider the duration of the price move of the underlying security. If the price of an underlying security is predicted to move from $15 to $30 in 3 months, buy options with an expiry of at least 4 months out as time decay occurs at the most rapid rate during the last 30 days of the option’s life.
Read : How to mitigate the effects of time value decay?
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
There is only 1 breakeven point for a long call. It can be calculated by:
Exercise or Strike Price Of Option + Net Debit
Step 5: Understand Your Profit Zones
Once the breakeven point has been calculated, the option trader will understand his profit zone. The price of the underlying security must trade above the breakeven point to be profitable. This can be visualised by drawing a vertical line that intersects the breakeven point perpendicularly.
Step 6 : Limited loss
If the call option expires worthless, the call option buyer loses the premium. This also necessarily means that his bet on the underlying security is wrong. A call option expires worthless when the price of the underlying security trades at or below the strike(exercise) price of the call on the expiration date of the call option. The loss of a long call is limited to the premium paid for the option.
Step 7 : Loss calculation
The maximum loss can be calculated as :
Premium paid for call + commissions paid to the broker
Step 8 : Potential for unlimited profits
A buyer of a call option has the potential for unlimited profits theoretically as the price of the underlying security can rise infinitely.
Step 9 : Calculation of profits
A long call strategy will be profitable when the price of the underlying security is greater than the sum of the strike(exercise) price of the call option and the premium paid for the option.
Profit is thus calculated as :
Price of the underlying security – strike(exercise) price of bought call – premiums paid for the call option
Step 10 : Calculate Risk & Reward Ratio
After calculating the maximum loss which is the net debit or premiums paid and the potential profit based on the price point at which a trader would like to exit at, the risk and reward ratio should be calculated. Is the reward worth the risk? Let us consider 2 trades. Trade A will yield $1 of potential profit for every $1 of risk while Trade B will yield $5 of potential profit for every $1 of risk. Trade B has a better risk and reward ratio than Trade A. Therefore, in this case, the trader should long calls for Trade B instead of Trade A.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade : Executing a long call
A trader can buy in the money calls , at the money calls or out of the money calls with the projection that the price moves of the underlying security will make his long call deep in the money.
Step 12 : Exit Trade
If the trade is making a reasonable profit , consider closing the position. If the possibility of a profit through an upside move in the underlying security is remote, consider closing the position for a loss.
Step 13 : Calculating the return on investment for a call option or the percentage profit/loss
The percentage profit can be calculated as :
Profit/cost of buying call option x 100%
The percentage loss can be calculated as:
Loss/cost of buying call option x 100%
Step 14 : Record Trade In Diary
After the trade has been exited, it should be recorded in a trading diary. If there were mistakes made during the trade, review the trade process and refine it so that you can become a better trader.
Example
PQR Corporation is trading at a price of $30. A trader buys a December 30 call as he projects that the price of PQR will rise to $40 by the expiration date of the option. He buys the December 30 call at a price of $2 and pays $200 of premium for it.
On expiration date, the price of PQR Corporation trades at $40. The call option is now in the money and the buyer of the call could exercise the right to buy 100 shares at the strike(exercise) price of $30 and sell the shares in the open market at a price of $40. In this way, he earns:
($40 – $30) x 100 – $200 = $800
He could also sell to close the long call by selling the call option at a price of $1000 as it is $10 in the money. His profit on the trade is thus:
$1000 – $200(premium paid initially) = $800
If the trading price of PQR Corporation trades at $15 on the expiration date of the option, the call option is now worthless and the maximum loss is the option premium paid to buy the call initially.
Read : Buy OTM or ATM Options With The Outlook That It Will Eventually Become Deep ITM Options
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