Buying Calls

For those who are very bullish on a particular stock over the near- or long-term, and who require a known, limited downside risk, buying a call might be an appropriate strategy to use. Purchasing a call option usually requires a smaller initial cash investment than an outright stock purchase, which in addition to reducing the capital at risk offers the potential of leveraged profits if a bullish opinion proves correct.

As the underlying stock continues to increase, the long call’s profit potential is theoretically unlimited, and larger returns on investment can be seen in comparison to an outright stock purchase. On the downside, the stock investor is exposed to a potentially significant dollar loss from a decline in share value, while the call buyer’s maximum loss is known in advance and is limited entirely to the option’s purchase price.

Who Should Consider Buying Equity Calls?

• An investor who is very bullish on a particular stock and wants to profit from a rise in its price.
• An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk.
• An investor who anticipates a rise in value of a particular stock but does not want to commit all of the capital needed to purchase shares.

Buying an equity call is one of the simplest and most popular strategies used by option investors. It allows an investor the opportunity to profit from an upward move in the price of the underlying stock, while having less capital at risk than with the outright purchase of an equivalent number of underlying shares, usually 100 shares per call contract.

Definition

Buying an equity call gives the owner the right, but not the obligation, to buy 100 shares of underlying stock at a specified price (the strike price) at any time before a specific time (the expiration date). This is a bullish strategy because the value of the call tends to increase as the price of the underlying stock rises, and this gain will increasingly reflect a rise in the value of the underlying stock when the market price moves above the option’s strike price.

The profit potential for the long call is unlimited as the underlying stock continues to rise. The financial risk is limited to the total premium paid for the option, no matter how low the underlying stock declines in price. The break-even point is an underlying stock price equal to the call’s strike price plus the premium paid for the contract. As with any long option, an increase in volatility has a positive financial effect on the long call strategy while decreasing volatility has a negative effect. Time decay has a negative effect.