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The sloping line indicates the theoretical profit or loss of the call option at trade expiration according to the price of the underlying assetLONG CALL In the long call strategy, you are purchasing the right, but not the obligation, to buy the underlying shares at a specific price until the expiration date. This strategy is used when you anticipate an increase in the price of the underlying stock. A long call strategy offers unlimited profit potential with limited downside risk. It is often used to get high leverage on an underlying security that you expect to increase in price. If you want to go long a call, your risk curve would look like the graph in Figure 4.8. When the underlying security price rises, you make money; when it falls, you lose money. This strategy provides unlimited profit potential with limited risk. It is often used to get high leverage on an underlying security that you expect to increase in price. Zero margin borrowing is allowed. That means that you dont have to hold any margin in your account to place the trade. You pay a premium (cost of the call), and this expenditure is your maximum risk. Perhaps the only drawback is that options have deadlines, after which you cannot recoup the premium it cost to buy them. Thus, you need to buy calls with enough time till expiration for the underlying to move into the profit zoneat least 90 daysor simply purchase LEAPS with a year or two until expiration. In addition, its best to buy calls with low implied volatility to lower the breakeven and minimize the debit to your account. Long Call Mechanics In this example, lets buy 1 March XYZ 50 Call @ 5.00, with XYZ trading at $50. This trade costs a total of $500 (5 100 = $500) plus commissions. The maximum risk is equal to the cost of the call premium or $500. The maximum reward is unlimited to the upside as underlying shares rise above the breakeven. The breakeven is calculated by adding the call premium to the strike price. In this example, the breakeven is 55 (50 + 5 = 55), which means the underlying shares have to rise above 55 for the trade to start making a profit. In Figure 4.8, note how the numbers that run from top to bottom indicate the profit and loss of this trade. The numbers that run left to right indicate the price of the underlying asset. The sloping line indicates the theoretical profit or loss of the call option at trade expiration according to the price of the underlying asset. Note how the loss is limited to the premium paid to purchase the call option. The risk graph of the long call shows unlimited profit potential and a limited risk capped at $500 (see Figure 4.8). The breakeven is calculated by adding the call premium to the strike price. The long call breakeven is slightly higher than the breakeven on the stock, but this is the trade-off a trader takes for opting for a position with less risk and a higher return on investment. Exiting the Position A long call strategy offers two distinct exit scenarios. Each scenario primarily depends on the movement of the underlying shares, although volatility can have a major impact as well. XYZ rises above the breakeven (55): Offset the position by selling a call option with the same strike price and expiration at an acceptable profit; or exercise the option to purchase shares of the underlying market at the lower strike. You can then hold these shares as part of your portfolio or sell them at a profit at the current higher market price. XYZ falls below the breakeven (55): If a reversal does not seem likely, contact your broker to offset the long call by selling an identical call to mitigate your loss. The most you can lose is the initial premium paid for the option. In this example, lets say XYZ rises 10 points to 60. There are two ways to take advantage of it: exercise or offset it. By exercising the March 50 call, you will become the owner of 100 shares of XYZ at the lower price of $50 per share. You can then sell the shares for the current price of $60 a share and pocket the difference of $1,000. But since you paid $500 for the option, this process reaps only a $500 profit ($1,000 - $500 = $500) minus commissions. The more profitable technique is to sell the March 50 call for the new premium of 14.75, an increase of 9.75 points. By offsetting the March 50 call, you can make a profit of $975 ($1,475 - $500 = $975)a 195 percent return! Conversely, if you had bought 100 shares of XYZ at $50 per share, you would have made a profit of $1,000 (not including commissions) when the shares reached $60 per sharean increase of 10 points. The profit on the long stock position is slightly higher than the profit on the long calla big $25. However, the return on investment is much higher for the long call position because the initial investment was significantly lower than the initial capital needed to buy the stock shares. While both trades offered profit-making opportunities, the long call position offered a significantly lower risk approach and the power to use the rest of the available trading capital in other trades. For an initial investment of $5,000, you could have purchased 10 call options and made a total profit of $9,750now, thats a healthy return. Strategy: Buy a call option. Market Opportunity: Look for a bullish market where a rise above the breakeven is anticipated. Maximum Risk: Limited to the amount paid for the call. Maximum Profit: Unlimited as the price of the underlying instrument rises above the breakeven. Breakeven: Call strike price + call option premium. Margin: None. The ability of a call option to be in-the-money by expiration is primarily determined by the movement of the underlying stock. It is therefore essential to know how to analyze stock markets so that you can accurately forecast future price action in order to pick the call with the best chance of making a profit. Understanding market movement is not an easy task. Although it takes time to accumulate market experience, you can learn how various strategies work without risking hard-earned cash by exploring paper trading techniques. Long Call Case Study In order to illustrate how the long call works in the real world, lets consider an example using a familiar nameIntel (INTC). Suppose you were studying some research notes on Intel and it seemed to you that the stock price had fallen too far given the outlook for the companys semiconductor sales. The chart pattern also seemed to suggest that the stock was due to move higher. With shares trading near $15.75, you expect it to move above $20 by year-end. So, you decide to establish a bullish trade on the chipmaker. Instead of buying shares, you decide to buy the INTC January 17.50 call. That is, you will buy the call option on Intel that has the strike price of 17.50 and has an expiration month of January. The current premium is $2.55 per contract and you buy 10 contracts. The total cost of the trade is therefore $2,550: (2.55 10) 100 = 2,550. Since Intel is trading near $16 a share at the time, this call is out-of-the-money. Many call buyers prefer to use out-of-the-money calls because they provide the most leverage. It is a very aggressive way to trade the market. To calculate the breakeven, we add the options strike price to the contract price, or 17.50 plus 2.55. The breakeven equals $20.05 a share. Often, traders will exit the long call strategy before expiration if the stock moves dramatically higher or falls too far below the breakeven. Recall that time decay is the greatest during the last 30 days of an options life. Therefore, it is best not to hold an option like the long call during that time. In addition, many traders will exit the position if it does not move in the anticipated direction. For example, if INTC drops below $15 a share, the trader might choose to close the trade. In that case, the $15 level would be considered a stop loss, or a predetermined price point where the trader exits a losing trade. In any case, rarely will the long call be exercised when it is purchased in anticipation of a move higher in the underlying security. Instead, the position is closed through an offsetting transaction. Specifically, you will sell 10 INTC January 17.50 calls to close. The chart in Figure 4.9 shows the risk graph for the INTC January Long Call Case Study Strategy: With the stock trading near $16 a share in February 2003, buy 10 INTC January 17.50 calls @ $2.55 and hold until the end of the year. Market Opportunity: The stock looks bullish and is expected to rise above $20 a share by January. Maximum Risk: Limited to the amount paid for 10 calls or $2,550. Maximum Profit: Unlimited as the price of the underlying instrument rises above the breakeven. In this case, the INTC January 17.50 call topped $30 a contract for an 11-month gain of 600 percent. Breakeven: Strike price + call option premium. In this case, 20.05: (17.50 + 2.55). Margin: None. 17.50 long call at the time the trade was established. We can see that if the stock falls the call will lose value. In contrast, profits begin to build as the stock moves higher. The maximum risk is equal to the premium, or $255 per contract. The upside potential is quite large. In fact, in this case, Intel not only rose above $20 a share that year, it topped $30. As a result, by the end of the year, the INTC January 17.50 call was worth $17.50 a contract for an 11-month 600 percent gain! Long Call versus Long Stock As you can see, a long call strategy has many advantages compared with buying stock. For claritys sake, lets review these advantages. Cost. The premium of an option is significantly lower than the amount required to purchase a stock. Limited risk. Since the maximum risk on a long call strategy is equal to the premium paid for the option, you know before entering the trade exactly how much money you could potentially lose. Unlimited reward. Once you hit breakeven (call strike price + call option premium = breakeven), you have unlimited reward potential as in a stock purchase. Increased leverage. Less initial investment also means that you can leverage your money a great deal more than the 2-for-1 leverage buying stock on margin offers. The only drawback is that options have a limited time until they expire. But even this disadvantage can be seen as an advantage if you consider the opportunity cost of waiting months and sometimes years for a stock that has taken a bearish turn to reverse direction. |
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