Long Call Explained

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Beginner’s Guide to Call Buying

The popular misconception that 90% of all options expire worthless frightens investors into mistakenly believing that if they buy options, they’ll lose money 90% of the time. But in actuality, the Chicago Board Options Exchange (CBOE) estimates that only about 30% of options expire worthless, while 10% are exercised, and the remaining 60% are traded out or closed by creating an offsetting position.

Key Takeaways

  • Buying calls and then selling or exercising them for a profit can be an excellent way to bolster your portfolio’s overall performance.
  • Investors most often buy calls when they are bullish on a stock or other security because it affords them leverage.
  • Call options dramatically reduce the maximum loss potential an investment may incur, unlike stocks, in which the entire value of the investment may be lost, should the share price dip to zero.

Call Buying Strategy

When you buy a call, you pay the option premium in exchange for the right to buy shares at a fixed price by a certain expiration date. Investors most often buy calls when they are bullish on a stock or other security because it affords them leverage.

Consider the following example: let’s assume that XYZ stock trades for $50. Let us further assume that a one-month call option on the stock costs $3. This presents a choice: would you rather buy 100 shares of XYZ for $5,000 or would you rather buy one call option for $300 ($3 x 100 shares), considering the payoff depends on closing prices one month from now? Still confused? Consider the following graphic illustration of the two different approaches:

As you can see, the payoff for each investment is different. While buying the stock will require an investment of $5,000, you can control an equal number of shares for just $300 by buying a call option. Also note that the breakeven price on the stock trade is $50 per share, while the breakeven price on the option trade is $53 per share (not factoring in commissions or fees).

While both investments have unlimited upside potential in the month following their purchase, the potential loss scenarios are vastly different. Case in point: while the biggest potential loss on the option is $300, the loss on the stock purchase can be the entire $5,000 initial investment, should the share price plummet to zero.

Closing the Position

Investors may close out their call positions by selling them back to the market or by having them exercised, in which case they must deliver cash to the counterparties who sold them. Continuing with our example, let’s assume that the stock was trading at $55 near the one-month expiration. Under this set of circumstances, you could sell your call for approximately $500 ($5 x 100 shares), which would give you a net profit of $200 ($500 minus the $300 premium).

Alternatively, you could have the call exercised, in which case you would be compelled to pay $5,000 ($50 x 100 shares) and the counterparty who sold you the call would deliver the shares. With this approach, the profit would also be $200 ($5,500 – $5,000 – $300 = $200). Note that the payoff from exercising or selling the call is an identical net profit of $200.

The Bottom Line

Trading calls can be an effective way of increasing exposure to stocks or other securities, without tying up a lot of funds. Such calls are used extensively by funds and large investors, allowing both to control large amounts of shares with relatively little capital.

Long Call

The Strategy

A long call gives you the right to buy the underlying stock at strike price A.

Calls may be used as an alternative to buying stock outright. You can profit if the stock rises, without taking on all of the downside risk that would result from owning the stock. It is also possible to gain leverage over a greater number of shares than you could afford to buy outright because calls are always less expensive than the stock itself.

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But be careful, especially with short-term out-of-the-money calls. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment, whereas if you own the stock it will usually still be worth something. (Except for certain banking stocks that shall remain nameless.)

Options Guy’s Tips

Don’t go overboard with the leverage you can get when buying calls. A general rule of thumb is this: If you’re used to buying 100 shares of stock per trade, buy one option contract (1 contract = 100 shares). If you’re comfortable buying 200 shares, buy two option contracts, and so on.

If you do purchase a call, you may wish to consider buying the contract in-the-money, since it’s likely to have a larger delta (that is, changes in the option’s value will correspond more closely with any change in the stock price). You can learn more about delta in Meet the Greeks. Try looking for a delta of .80 or greater if possible. In-the-money options are more expensive because they have intrinsic value, but you get what you pay for.

The Setup

  • Buy a call, strike price A
  • Generally, the stock price will be at or above strike A

Who Should Run It

Veterans and higher

NOTE: Many rookies begin trading options by purchasing out-of-the-money short-term calls. That’s because they tend to be cheap, and you can buy a lot of them. However, they’re probably not the best way to get your feet wet. The Rookie’s Corner suggests other plays more suited to beginning options traders.

When to Run It

You’re bullish as a matador.

Break-even at Expiration

Strike A plus the cost of the call.

The Sweet Spot

The stock goes through the roof.

Maximum Potential Profit

There’s a theoretically unlimited profit potential, if the stock goes to infinity. (Please note: We’ve never seen a stock go to infinity. Sorry.)

Maximum Potential Loss

Risk is limited to the premium paid for the call option.

Ally Invest Margin Requirement

After the trade is paid for, no additional margin is required.

As Time Goes By

For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.

Implied Volatility

After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction (but you’ll hope the direction is up).

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.
  • Remember: if out-of-the-money options are cheap, they’re usually cheap for a reason. Use the Probability Calculator to help you form an opinion on your option’s chances of expiring in-the-money.
  • Use the Technical Analysis Tool to look for bullish indicators.

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Short Call

The converse strategy to the long call. The short call strategy involves the selling of call options. Selling of call options is more commonly known as call writing.

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