optionMONSTER®

Would you like to...

• Have more leverage without increasing use of margin?
• Have a low-capital, low-risk way of profiting from rising stock prices?

You think XYZ stock is going to go up in the near future. You don't really want to tie up all the capital necessary to profit, and you don't want to pay margin rates. But you still want leverage. As one top hedge fund manager said, "the only way most people really do well in the markets is to be long and leveraged". Buying calls is the best way to be "long and leveraged".

Buying calls is the one options strategy most every option trader has executed. Calls are a bet on the rise in price of the underlying stock. This is the option strategy that is most like buying stocks, and so is a popular entry into options trading. Calls are a limited-risk way to profit from rising prices in the underlying, and thus provide for leveraged speculation.

Table of Contents

• What is a Long Call?
• Rules for Buying
• Exiting Long Calls
• Example of a Winning Trade
• Example of a Losing Trade
• Summary

What is a Long Call?

Buying calls gives you the ability to control a lot of stock without owning it, or "leverage." Equity calls give the buyer the right to buy 100 shares of an underlying stock or exchange traded funds (ETFs) at a designated strike price until the expiration date. Long calls are used to profit from upward moves in the underlying.

Buying calls is as simple as picking the strike and expiration date that you wish to buy. Call buyers often use out-of-the-money options (when the strike is above the stock price) because they are "cheap" and appear to offer the best leverage. Speculators and traders must keep in mind, however, that out-of-the-money options also offer a lower probability of profit.

Long calls have significant profit potential, as holders generally will make money as the stock moves up. Because you are paying a premium, in essence buying time value, the stock has to rise above the strike price plus the cost of the contract to be profitable at expiration. Significant upward price moves will benefit the position. Long calls also benefit from an increase in implied volatility (because the likelihood of movement, which is implied by the price of the option, is the key component of the time value of the option contract's price). Option buyers are best served by divesting their long positions as expiration gets close, however, as that is when time decay is greatest.

The long call strategy loses if the stock price, at expiration, is below the strike price plus the premium paid. The maximum risk is the amount paid for the call. Clearly if the underlying price falls, the position will lose value. If the implied volatility drops (thus lowering the time value of the option), the position can also lose value, even if the underlying moves up. This is the reason that buying calls before earnings (or other news) can be a risky strategy. Even if the stock moves up, the drop in implied volatility that often happens after earnings are released can more than offset the gain from the move in the underlying.

Example: You purchase the GOOG 500 call option for $25 while Google stock is trading for $500. If GOOG goes up to $550 before expiration, then your call will be worth at least $50. This gives you a 100 percent return on the call option (before counting the cost of the option) with just a 10 percent gain on the stock. That what is meant by the leverage of buying options.



The flip side is that if the stock does not move up, then the option will lose all of its value by expiration. This is the result of the decay of the premium of the option, known as time decay. That is the risk of buying calls. Since they are expiring assets, they have time value that diminishes over time. But regardless of how far the stock falls, your risk is limited to the cost of the call.

GOOG	Stock P/L	% Return	Call P/L	% Return
$200	($300)	-60%	($25)	-100%
$500	0	0%	($25)	-100%
$550	$50	10%	$25	100%
$600	$100	20%	$75	300%

The long call will profit from the stock price rising, all else held equal. The position will lose as the stock price moves down, but that loss is capped at the $25 paid for the position. Because implied volatility is a significant part of the premium paid for an option, if implied volatility goes down, the long call will lose value, and if implied volatility goes up, it will gain. This is only the case before expiration, because at expiration profit and loss is fixed. Time is against you with a long call, so every day you are losing value from time decay.

Rules for Buying

Regardless of whether you are buying calls or puts, there are some general rules to follow. One, the expiration should give the option enough time to perform without being overexposed to time decay. Since options have an expiration date, a large part of their value is time value (for more, see our lesson on Options Pricing). This time value will deteriorate as that expiration approaches; time decay increases exponentially in the last 30 to 45 days of an options life, so this is usually not the time to own options.



Two, options should generally be bought when the time value - primarily influenced by a factor known as implied volatility, or the expected price swings of the underlying - is expected to stay flat or to rise. Buying options is a limited-risk strategy, and all of that risk lies in the premium paid for the option. If there is a rise in implied volatility, then there will be a rise in the option premiums. This increase can produce profits for long options, even if the stock price doesn't move, because the chance of movement has increased. Conversely, if you buy options when implied volatility and premiums are high, such as before earnings, then the stock can move in the direction that you want and you can still lose money, because with the news out, the implied volatility could fall.

Finally, when you buy an option, generally you will want to sell it, ideally for a still-greater premium. You do not want it to expire, since you will receive zero premium, and normally you don't want to exercise your right to purchase the underlying shares, unless that is your particular strategy (say for tax reasons). In both of these cases, you lose whatever time value is left in the option. So with future resale value in mind, we can see why risk management rules are important, such as taking profits when your position doubles or closing out the position when it loses half of their entry value.

Exiting Long Calls

When a call has been purchased, the position can be closed in one of three ways:

• Selling the call - Once an option is bought it can be sold at any time, and this is the most common way of exiting a long position. This is the only way of exiting a long call that captures any remaining time value in the option.
• Letting it expire - If a call gets all the way to expiration, it will expire, worthless if it is out of the money (when the strike price is above the stock price - see Options Pricing). If the stock price is above the strike price by $.01 or more, it will be automatically exercised and shares will be delivered to your brokerage account. Long calls are almost always sold before expiring, as at that point they will have lost all time value.
• Exercising you call - Utilizing the "right to buy" that is inherent in the call contract is known as exercising the option. This delivers shares of the stock to you at the strike price. Options are rarely bought with the intention of exercising the underlying right. Taking this course also forgoes any remaining time value in the option.

Example of a Winning Trade

• In the circled area, the price of Intel (INTC) bounces off a low while implied volatilities, and hence option premiums, stay low. Ideally we want to buy calls on low implied volatility because that means that there is less time decay working against us.
  
  
• Time decay is the greatest in the last month before expiration, so in this case, with the stock climbing back above $25 and implied volatility at 30%, we would buy three months out, February 27.5 calls for $.70.
• If the underlying price rises, and implied volatility does not drop (as was the case), it is best to sell the call and not hold it all the way to expiration, thereby losing any time value.
• In this case, the stock hit $28 within two weeks and implied volatility went to 34%. The option went from $.70 to $2.10.
• Using disciplined position management, we would have exited this position before the full gain, taking half of the position off after a 100% gain, and selling most of the rest at a 200% gain. The reason to do so is to avoid letting a winner become a loser - since we could not have known the future trajectory of the option.

Example of a Losing Trade

• Three things can go against us when buying calls: 1) Underlying direction, 2) Implied volatility, and 3) Time.
  
  
• Using the same underlying as on the previous page, if we had bought calls a month earlier, the trade might not have worked out as well. In the highlighted area we see INTC breaking out to a new high. But most options traders ignore implied volatility and buy out-of-the-money calls only in the near months.
• So with the stock at 26.50 and the implied volatility at 41%, we could have bought the November 27 call for $1.10.
• The price did move up to 27.50, but with time decay and the drop in implied volatility, the position showed a loss, with the value drooping to $.99. The price then fell further and took the option price down to $.55, where our 50% stop-loss limit would have been hit and we would exit the trade.

Summary

• Long calls are a bullish position.
• They can be a limited-risk, leveraged way to profit from rising prices in the underlying.
• They are significantly affected by implied volatility and time decay.
• The maximum risk is limited, while the maximum gain is theoretically unlimited.

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Options data for ActionTracker provided by Wolverine Trading Technology, LLC. Market data powered by QuoteMedia, fundamentals by Hemscott. All data delayed by 15 to 20 minutes unless otherwise indicated.

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Copyright © 2010 OptionMonster® Holdings, Inc. All rights reserved
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