Long Call Option Explained
A long call option is the most basic and generally traded contract that new investors will use as they transition from stock trading.
A call option is purchased when you have the expectation that the underlying stock will rise in the future.
As a call option buyer you will pay a premium now for the right to purchase shares in the future at some predetermined price. This premium is then added to the share price that you have selected (your strike price) to determine your break-even point.
Compared to buying the stock out-right, a call option buyer is using leverage by controlling 100 shares of stock for each 1 call option purchased.
We’re going to talk about the most basic options strategy that there is, really, the foundation of every other strategy out there or at least one of the foundational building blocks and that is a long call option.
It’s probably the most widely used, widely traded at the beginning with beginner traders, so we’re going to go over that in detail in this video.
Starting with the market outlook, a long call option is a strategy that you implore when you think that the stock prices are going to rise significantly beyond the strike price before expiration.
This is a very bullish strategy. You’re looking to buy a call option on a stock and see the stock rise much, much further than your strike price. And what that does is that allows you to buy the stock at the strike price and then sell it back to the market (if you so choose) at the higher market price.
This is going to give you a tremendous amount of leverage about the market compared to buying these shares outright. A call option is going to give you the power to control 100 shares of stock for just one call option.
You could see in effect, trade ten call options and control 1000 shares of stock. It’d be much cheaper to buy the option than it would be to buy the stock outright.
Now, how do you set this up? These are very easy to set up. It’s just a single leg option order. What you’re going to do is simply buy a call option with a strike price and expiration period that you desire.
So, you can buy these at various strike prices, in the money, out of the money, at the money strikes and you can also buy them at various expiration periods, depending on what your outlook is for the stock.
If you don't think the stock is going to move until next month, well then maybe you’ll buy an option for the following month or two months beyond there just to give yourself some extra time.
But it's very easy to set up. It’s just a single order that you place in your broker platform. Now, the more bullish you are, the further out of the money you can buy the call option. Let me explain.
Like we talked about before, for you to make money on this strategy, it has to be much, much further than your strike price at expiration. If the stock is trading at let’s say 30, right here where my cursor is, and you're bullish on the stock, you could buy a call option at say 40, right here where this call option pivots and that's a 40 strike.
This means that you’re bullish and you think the stock is going to move beyond $10 by expiration for you to start to make money.
Now, this option is going to be cheaper than if you let’s say for example, bought an option while the stock was trading at 40, you bought the 40 strike which is on the money, so an at the money call option, it’s going to be a little bit more expensive because it doesn't have as much distance to move before it starts making money.
You can buy these at different ranges, but the more out of the money you are, the more bullish you are on the stock. What's the risk? Well, the risk on all options that you buy, long options is completely capped at the premium that you pay for that option.
If you hold the call all the way till expiration and the stock never move higher, then where it was when you entered, and it never moves into a profit range, then you’d be looking at an option that's going to lose just the value of the premium that you paid for that option.
Sometimes traders will pay as little as $10 for an option, and that's the most risk that they have. Now, the good thing is that the profit potential of these is theoretically unlimited, a stock can rise to infinity, it has no upper boundary.
But at some point, the contract is going to reach parity which means that it’s going to act just like the stock. If it continues to rise so far so fast, it's going move just like the stock, and you’re going to lose that leverage that you have, so you might as well convert it.
But for all intensive purposes, the profit potential for long calls and more or less, long puts is very, very much unlimited. You have a huge potential with minimal risk.
Now, volatility is going to be an important factor about long call options. Generally speaking, an increase in implied volatility is going to have a positive impact on this strategy, everything else being equal.
If general market volatility increases, that's going to tend to boost the value of these options because there’s a greater chance that the stock may swing into a profitable range.
During low volatility times where the stock is trading let's say right around 40, there's not that high of a likelihood that it’s going to swing wildly between 50 and 30. If it’s trading right around 40, low volatility, then there's not that high of a probability that it’s going to move into your profit zone.
As always, at the money options are going to behave differently than something that's out of the money. Obviously, if the stock is trading at $20 and our strike here is at 40, then this is going to be a wildly out of the money option, so even a big volatility move may not even impact this option.
You just have to look at different volatility pricing factors and as always, check some of the other video tutorials that we have to learn more about volatility and options.
Time decay is going to be also an important factor for long call options. We all know that options have a finite life. That’s expiration. It’s the point at which they stop trading, and you have to make a decision on whether you want to get rid of the option or exercise it or have it assigned.
Every day that passes that this option doesn't make money, it's losing money, it’s losing value, it's getting close to that expiration period, it’s kind of like it’s withering away. We want to trade this on a stock that is going to move.
A stock that doesn't move is not going to be profitable for this type of strategy and that’s because the time decay value is going to continue to disappear and degrade the value of the option throughout the expiration cycle.
If at expiration, the stock is anywhere below your strike price with a long call, then you’re going to lose all of your premia that you outlaid, and that’s your max loss.
If at expiration, the stock is above your strike price, then you’re going to make the difference between the stock price and your strike price and then again, factoring in your premium that you paid for the option.
Again, let's talk about that breakeven point right now since we were on it. Like we were talking about, at expiration, the strategy will break even if the stock price is equal to the strike price plus the initial cost of the call option.
All you’re going to do is take the strike price of the long call, in our case, that's $40, it’s right here where the option payoff diagram pivots, and you’re going to add the premium that you paid, in our case, $200, that's the premium that we paid for this option.
That creates our breakeven period. That's when we start to the net, make money on the strategy. That's the period that we want to watch on the chart. That's where the stock has to move beyond by expiration. Let's look at an example again just to drive home the point.
Let's say that the stock price is trading at $40. We’re going to buy one 40 strike call, and that’s going to be right for the money, so we’re going to buy an option right at the money here, and we’re going to pay about $200 for that call option.
That $200 is going to be a debit on the trade, meaning that that money is going to come out of your trading account, you’re going to pay that price and receive that option. Now, your max loss on the trade is only $200. That’s the cost of the option. You can't lose any more than that.
And again, here's the best feature and that’s your max profit. Your max profit is theoretically unlimited because the stock price can rise to whatever price. Now again, this is much different than if you traded the individual stock.
If you bought the stock at 40 outright, your max loss would be if the stock goes all the way down to zero. Here, the stock can crash to zero and you still only lose your $200 investment.
Some tips and tricks regarding long call options. This is a very popular strategy, and it’s the building block for other complex strategies. It's really important that you understand how a call option works independently of everything else.
And this is a key feature here with call options, is that you have to understand how single leg options work. It’s that when you start overlapping them with other options, let’s say short calls and short puts and long puts and long calls; then you understand how they all work together.
But it's important that you understand how just the basic building blocks work about volatility and time decay as we've gone over here. I always tell people to tend to focus on the at the money or slightly out of the money call options when you're buying for speculating.
If you’re going to buy a call option to hedge a short position in the market, then you want to focus on things that are more out of the money and therefore, cheaper. You don’t want to pay such a high price.
But if you’re going to speculate on the direction of the stock, i.e. you think that the stock price is going to move up considerably, focus on buying options that are at the money or slightly out of the money. They’re going to be a little bit more expensive, but they’re also going to make money quicker.
Some of those options that are deep out of the money that are $5 and $10, although they look really attractive on a price level, meaning that they’re really cheap prices, they’re cheap for a reason, and that reason is because they don't have a high likelihood of making money, so they’re not going to be expensive.
Nothing has a value that’s that cheap. Focus on these options that are around the current stock price when you’re trading. As always, I hope you guys enjoyed this video and thanks for watching. Take just one second here to share this video right below here on any of your favorite social networks with your friends, family or colleagues.
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