Long Call Trading Strategy

When to Use the Long Call

The primary use of the long call is when your outlook is bullish, meaning you expect a security to go up in value. It's best used when you expect the security to increase significantly in price in a relatively short period of time. Although there are still benefits to using it if you believe the security will rise more slowly over time. You just need to be aware of the effects of time decay, because the time value of calls will depreciate over time.

Generally speaking, any time you have a bullish outlook on a security you could consider using the long call. However, there are probably better alternatives if you are only anticipating that the price of the security will increase a little.

Why Use the Long Call

This is a good strategy to use for a number of reasons. For one thing it's really simple, so the calculations involved are quite straightforward. It's essentially an alternative to buying an asset that you expect to increase in value, but because of the leverage power that options have you can make a greater return on your investment.

The downside risk is lower than investing directly in an asset, because the most you can lose is the cost of the calls that you buy. No matter how much the underlying security drops in value this is true. It's also flexible, as you can effectively select the risk to reward ratio of the trade by choosing the strike price of the options contracts you buy.

How to Use the Long Call

As we have mentioned, this is an incredibly straightforward strategy. The only transaction involved is using the buy to open order to purchase calls on the security that you believe is going to increase in price. You can buy either American style or European style contracts, depending on whether you want the flexibility of being able to exercise at any time or not. That flexibility does come at a cost, though, as American style contracts are typically more expensive than the European style equivalent.

There are other specific decisions that you need to make too; what expiration date to use and what strike price are two examples. If you are expecting the underlying security to quickly rise in price, then buying contracts with a short time until expiration makes sense. If you think the underlying security will take longer to rise, then you will need to buy longer term contracts. Longer term contracts will usually cost a little more, because they will have more time premium associated with them.

What strike price to use takes a little more consideration, although we would generally recommend that beginner traders just buy contracts that are at the money, or very near to the money.

For the more experienced traders, you may like to compare the delta values of options with different strike prices, and determine which strike price to use based on the returns that you are looking to make and exactly what you expect to happen to the price of the underlying security.

For example, if you were expecting a sharp increase in the price then buying cheaper out of the money contracts may enable you to maximize your returns. If you were expecting a more moderate increase in the price, then buying in the money contracts with a higher delta value may be the better choice. There is not particularly a right or wrong approach to making this decision; it ultimately comes down to your own expectations and what you are hoping to achieve from the trade.

How the Long Call Profits

The relevant underlying security simply needs to increase in price sufficiently. Broadly speaking, the more the underlying security increases in price, the more profit this strategy will generate. There are two ways that you can realize any profit that this strategy makes: either by selling the calls when they have gone up in price, or by exercising them to buy the underlying security at the strike price, and then selling it at the current trading price.

Selling the calls is a more common choice for most traders, but there may well be circumstances when buying the underlying security is a better solution.

Risks

The maximum loss of this strategy is limited to the amount of the net debit you have to pay when implementing it. The worse-case scenario is that the contracts purchased expire worthless when the underlying security fails to move above the strike price. It's also possible to lose money if the underlying security does increase in price, but not by enough to cover the cost of the contracts and/or the effect of time decay.

Advantages & Disadvantages

There are many advantages of this strategy, and not too much in the way of disadvantages. Arguably the biggest advantage is the fact that it's possible to profit from the underlying security increasing in price while limiting losses if it falls. The inherent leverage offered by calls also means that it's possible to make profits comparable to actually owning the underlying security, but without having to invest as much capital.

This makes it an ideal strategy for traders that don’t have a huge amount of money to trade with. Alternatively, if you do have plenty of capital to invest, you could potentially make much bigger returns than you could by investing the same amount directly in the underlying security.

The simplicity is also a big advantage, particularly for beginners. It's easier to calculate the potential profits than it is with some of the more complex strategies, and less transactions means paying less in commissions. There's also no margin required and you know exactly what your maximum loss is at the start. It's also easy to make further transactions and convert the strategy into an alternative one should your outlook change.

The main disadvantage is that you have no protection against the underlying stock falling in value. You run the risk of losing everything you invested in the strategy if the calls you bought expire out of the money. You are also exposed to the effects of time decay, because the extrinsic value of calls is negatively affected as time passes.

Example

Here we have provided an example of the long call strategy, showing how it would be used and a few potential outcomes at the point of expiration. Please be aware this example is purely to provide a rough overview of how it can work and it doesn't necessarily use exact prices. For the purposes of this example we have ignored the commission costs,

Initial Trade

• Company X stock is trading at $50, and you expect it to increase in value.
• At the money calls on Company X stock (strike price $50) are trading at $2.
• You purchase 1 call contract (one contract covers 100 options) for an investment of $200.

If Company X stock increases to $52 by expiration

Your contracts will be worth roughly what you paid for them and you will break even on the trade at expiry. You could exercise them to buy 100 shares at $50 each and either sell them for a profit or hold on to them if you felt they would increase further in price. Alternatively you could sell the contracts just before expiration.

If Company X stock increases to $55 by expiration

Your contracts will be worth roughly $500 and taking into account your initial investment of $200, you will have made a profit of around $300. You could either exercise them or sell them just before expiration for a profit.

If Company X Stock falls or does not increase by expiration

Your contracts would expire worthless, and you would lose your initial investment.

Remember, you don't have to hold your options all the way until expiration. Their price will increase as the price of Company X stock increases, so you can sell them for a profit at any point if you choose. Equally, if the price of Company X stock is falling or staying stable, then you could sell them to recover any remaining extrinsic value and reduce your potential losses.

Profit, Loss & Break-Even Calculations

• Maximum profit is unlimited.
• Profit is made when “Price of Underlying Security > (Strike Price + Price of Option)”
• Profit per option owned is “Price of Underlying Security – (Strike Price + Price Of Option)”
• Maximum loss is limited
• Maximum loss is made when “Price of Underlying Security < or = Strike Price”
• Maximum loss per option owned is “Price of Option”
• Break-even point is when “Price of Underlying Security = (Strike Price + Price of Option)”

Summary

This is a simple strategy that is ideal to use when you are expecting a security to increase in price significantly and quickly. It's very simple and well suited to beginners; it's a great way to get started with options trading.

The potential profits are theoretically unlimited, and yet the potential losses are limited to the money invested in the calls when making the trade.