Introduction To Long Call Option 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.
Buying a call option contract also gives an investor the right to buy shares in the underlying security. Hence, the investor or trader can exercise the right to own shares or the underlying security. Why would an investor or trader do this? An investor or trader would most likely do this if he has a long term view of the underlying security. Instead of holding on to a call option contract that can expire worthless due to its limited lifespan, the investor may opt to buy the shares instead.
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.
Net Debit
Executing a long call will result in a net debit to the trader’s account.
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 In Long Call
Step 7 : Calculating Maximum Loss In A Long Call Strategy
Step 8 : Profit
Step 9 : Calculate Profit In A Long Call Strategy
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade
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
It is essential for a trader to perform economic, fundamental and technical analysis before placing a long call strategy. This is because options go through a process of time decay which causes the option premium to decrease in value over time if all things stay constant. The trader should also review price and volume trends over the last 12 months. Some suggested chart patterns that the trader should look out for are:
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. Review option premiums and investigate implied volatility. The lower the implied volatility, the lower the option premium. 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
After step 3, the options trader should calculate the breakeven point. The breakeven point is equal to : Exercise(strike) price + Option premium paid
Step 5: Understand Your Profit Zones
The profit zone of a long call is to the right of the breakeven point. The trader should project that the price of the underlying security will eventually trade above the breakeven point over the life of the option.
Step 6 : Limited Loss In Long Call
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 : Calculating Maximum Loss In A Long Call Strategy
The loss can be calculated as:
Call Premium Paid + Commissions paid to broker
Step 8 : Profit
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 : Calculate Profit In A Long Call Strategy
The profit can be calculated as :
Price Of Underlying Security – Breakeven point
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 based on possible exit points. Is the reward worth the risk? This will tell a trader if a trade is relatively more attractive to other trades of a similar nature 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
Buy or long call option contract at a certain strike price and expiration date. Make sure that economic, fundamental and technical outlook are pointed towards the same direction : Upwards.
Step 12 : Exit Trade
An exit plan should preferably be in place before the trade is placed. Determine a profit and loss percentage to exit the trade at. This can be determined by technical analysis. If there are 30 days left to expiration, the trade should also be exited as the option will suffer a drastic decline in value attributable to time value erosion. If the price of the underlying security rises above the breakeven point, the trader can sell the option or exercise the option to own shares so that the shares can be sold at a much higher price later on. If the price of the underlying security falls below the breakeven point, the option can be sold to reduce the loss. The maximum loss is the net debit paid.
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
Record the trade in a diary for review, reflection and analysis.
Example Of A Long Call
Trader Z buys 10 Dec 30 call option contracts on Company XYZ. The current price of the call options are $2. Hence, the trader pays a total of :
$2 x 100 x 10 = $2000
The price of the company XYZ rises to $40 and the trader sell the options at a price of $10. The profit is thus:
($10 – $2) x 100 x 10 = $8000
Long call vs Short call
The short call is the opposing trade to the long call. The short call can incur an unlimited loss while the long call has unlimited profit potential.
Read : Comparisons of long call vs long stock
Buying options : Long call & put options
Buy a call option before earnings announcement if you expect a price spike
Comparisons of long call vs long stock
If you bought this call option before earnings announcement, you would have made a killing!