Purchasing or selling long call options is the simplest form of options trading to comprehend. It's similar to buying long stock in a company, except that you either buy the right or sell the right to purchase the underlying shares in a company. Since call options are bullish to very bullish in terms of strategy, trading call options gives you leverage on a long stock position as well.
Long Call Options Diagram
At first, options trading seems intimidating, which is why I recommend looking at graphs to build a visual conception of how long call function in the options market. There are 3 characteristics to understand:
- Strike Price
- Break Even Point
- the relationship between options and the underlying stock
1. Options Strike Price
I defined options strike prices in my last post, but so I won't spend too much time on this concept. It's simply a fixed price level on the underlying stock, comparable to a watermark in a bucket.
2. Options Break Even Point
This refers to the point where the value of your options appreciates in equal value to your purchase premium and may become profitable (i.e. ITM or in-the-money options). When your options reach the break even point, you've placed a profitable options trade.
Unless the underlying stock moves upwards rather quickly, your trade is out-of-the money, meaning the trade has no intrinsic value and negative value. Another way to view the break even point is simply the strike price plus the premium you paid for the options.
3. Relationship between Stock and its call options
This concept may confuse you at first, but there are Greek options concepts which determine the relationship between a stock's value and the value of its stock options. I won't dig into the Greeks yet, because that's a whole different blog post. But it's important to grasp that your options become more profitable as the underlying stock gains in value.
Although time value, the days between the options expiration date and the current date, degrade an options value over time, it's best to buy long call options at least 3 months in advance to avoid time-value losses. As the expiration date nears, and especially within 30 days, the value of your call options depreciates rapidly.
Benefits of Long Call Options
1. Minimum Risk, Unlimited Reward
Maximum Risk: Premium Paid for Options
Maximum Profit: Unlimited – depends on how much your options appreciate in value
When trading long call options, your risk-taking is limited to the value paid for the options, period. That's why so many traders and investors refer to options trading as “the investment of the rich.”
If you're bullish on a stock, buying long call options give you full control over your investment, and present a vast amount of liquidity since you may exercise your options, do nothing and let them expire, or resell your options back into the options market.
2. Options are a form of insurance
Do you own home, auto, or life insurance? If so, then you already have some understanding of options trading, since options were introduced to provide investors with a significant amount of insurance. You pay a small amount to protect or hedge your investment in case of an emergency, much like one purchases auto insurance in case of an accident.
If your car remains unharmed, then you lose the premium paid for the auto insurance, right? Well, the same principle applies in call options, except that you may sell your options back into the market place before they expire. 60% of all options contracts are sold back into the marketplace, mainly because the owner felt no reason to exercise and purchase the underlying stock or let the options expire worthless.
3. Utilize your long stock picking strategies for a fraction of the cost
I follow Google Inc. shares (GOOG) daily, yet never accumulate enough funds to open a realistic position in the stock. Google Shares cost $470 a pop, so I could only purchase 1 share at most. Sound familiar? You want to open a position in a stock, but the shares either are too expensive or trade at extreme levels.
The Solution: Google Stock Options
If you're bullish on Google Stock (I sure am), then the perfect solution is long call options. Below is a snapshot of a typical options chain from my TradeKing brokerage account:
You can purchase long options on shares of Google Inc. for only $10.30 at a strike price of $470, giving you the right to control 100 Shares of GOOG. While your initial call options investment requires at least $1030 to open ($10.30 per options call x 100 = $1030), you could only purchase 2 shares of Google for the same price! Yes, option trading is a very good deal.
Closing Thoughts on Long Call Options
Long call options are my favorite type of options because they mesh well with my long-term stock picking methods. Call Options come in various formats – 1 month, 3 month, 6 month, 1 year, and 2 years from expiration, so there is lots of versatility in stock option chains. You may consider trading call options on paper before risking your money in the live options market.
Important Bonus Video! Click Here to Watch A Free Video Tutorial on the Basics of Stock Options Trading