Long Calls - Definition
Investors will typically buy call options when they expect that a underlying's price will increase significantly in the near future, but do not have enough money to buy the actual stock (or if they think that implied volatility will increase before the option expires - more on this later).
A call is an option contract that gives the purchaser the right, but not the obligation, to buy stock at a certain price (called the strike price). If the stock goes up, the value of the call contract also goes up. If the stock goes down, the value of the call option goes down.
Think of buying call options like this, keeping in mind that this is a slightly simplified example:
You have an inclination that GOOG (ticker symbol for Google) is going to increase quite a bit because they have a new product rolling out. You want to invest in them, but you do not have a lot of money to do so (GOOG is currently trading at $940 so buying 100 shares would cost you $94,000). Buying one call option contract allows you to control 100 shares of stock without owning them outright, for a much cheaper price.
Let's say I sell you a call option in GOOG for $1,020 (called a debit), at a strike price of $985, that will expire in 39 days (every option bought or sold will always have an expiration date). You pay me the $1,020 which gives you the right, but not the obligation, to purchase 100 shares of the stock at the predetermined strike price - which in this example is $985.
If the stock price ends up trading at a range above the $985 strike price (where you make a profit), you can sell the call option back and take the profit, or you can exercise it and buy 100 shares of GOOG at the $985 strike price. Because you don't have enough money to exercise the option, you would choose to take the profits and close the trade out.
If the stock price is not above the $985 strike price by the time the option expires, the option will expire worthless and I get to keep the $1,020 you gave to me initially.
The difference between buying stock and buying a call option is that with a long call option, the most one can possibly lose is the price they paid for the option, whereas with owning stock, the price can continue decreasing all the way to $0 (an unlikely scenario, but still a consideration when choosing the best type of investment to make).
Unlike owning stock (which has no expiration), owning a call could result in either a full loss of the call's value, or unlimited profit potential at expiration. The purchaser is not obligated to buy the stock at expiration because they can sell the call at any point in time (as long as the underlying is liquid enough). The drawback of owning a call is that there is no long-term residual value.
Now that you understand the basics of buying call options, let's dig into how the purchase of a call option affects the amount of money in your account (aka your buying power).
Buying Power Reduction
In a brokerage account, the buying power reduction of buying a call is equal to the debit (cost) paid to put on the trade. In the below example, I paid $1,020.00 to put the trade on so that is what my buying power reduction is. It's that simple.
Now, let's take a look at when your long call will be profitable and when it will expire worthless.
When A Long Call Will Be Profitable
A long call option will be profitable once the price of the stock moves above the strike price of the option + the debit paid for the long call. Once it moves past this mark, there is unlimited profit potential. A long call can be purchased in the money or out of the money, which I will explain next.
In The Money
Below is an example of buying a call option that is 'in the money' (ITM). To figure out at what price this trade will be profitable, you add together the strike price of the option, which is (b) $900.00 and the debit paid for the trade, which is (c) $54.20. The math looks like this: (b) $900 + (c) $54.20 = (a) $954.20. In this example, (a) $954.20, represents the long call's breakeven price.
You can see in the image below that the long call is profitable once the price of the stock rises above the breakeven point of (a) $954.20 (represented by the green profit zone in the tastyworks trading platform).
Out Of The Money
A variation of this is an 'out of the money' (OTM) long call option, which works the exact same way. The trade is profitable once the price of the stock goes above the breakeven price (b) $995.20, which is equal to (a) $985 (the strike price of the call) + (c) $10.20 (the debit paid for the trade). See the below example for a visual.
*It's important to note that because market conditions are always changing, option pricing can be affected by implied volatility (which gets into a more complicated topic - theta decay), but for simplicity's sake, we have not factored that into this post.
When A Long Call Will Lose Money
A long call option will lose money if the price of the stock never moves above the breakeven price, or said differently, strike price of the option + the debit paid for the long call.
You can see in the below example that the long call loses money if the stock prices ends up below the breakeven price (b) $995.20 - which again is the total of the strike price (a) $985 + (c) $10.20 (the debit paid for the trade).
If the stock price ends up between (b) $985 and (b) $995.20 (represented by the gray area in the below image), the trade will lose anywhere from $.01 - $10.20/share of stock (remember that 1 call option controls 100 shares of stock).
The trade will be at maximum loss if it expires at or below (d) $985, represented by the red area in the image below. This holds true for both in the money long call options as well as out of the money long call options.
*Again, remember that because market conditions are always changing, option pricing can be affected by implied volatility (which gets into a more complicated topic - theta decay), but for simplicity's sake, we have not factored that into this post.
Now that you grasp when a long call will be profitable and when it will lose money, let's discuss the ideal conditions for placing a long call option.
Opening the Trade: Market Conditions
Market Conditions - a long call would be placed if you have a bullish assumption of the market/underlying; long call options are traded when an investor expects the underlying's price to have a significant move upwards.
IV Rank - it's best to place long calls in underlyings with low IV rank. Why is this? The debit paid (the price paid for the option) will be less for underlyings with a low IV rank as opposed to a high IV rank. As implied volatility increases, the market is indicating a greater expected range of the movement in the underlying. Therefore, option sellers demand a higher premium because underlyings with a high IV rank are much more likely to have larger price shifts and vice versa.
Closing the Trade
To close a long call, an investor can do one of three things:
- Wait until the long call expires - in which case the price of the stock at the close on expiration dictates how much profit/loss occurs on the trade.
- Sell a call before expiration - in which case the price of the option at the time of sale dictates how much profit/loss occurs on the trade.
- Exercise the long call - receive 100 shares of stock at the strike price of the option.
The exit strategy depends on the goal of the investor, but for investors who do not have the capital required to buy the stock, options 1 and 2 are the only options (no pun intended).
When Will The Options Get Assigned Stock
With a long call option, you will not automatically be assigned stock. At any point, you have the right to exercise the long call and buy the 100 shares agreed upon when undertaking the option contract, but you do not have to exercise this right.
If you have additional questions about long calls, drop it in the comments sections or shoot our support team an email at firstname.lastname@example.org.