The Long Call Strategy
Most investors start by buying stock, and they are used to thinking in terms of purchasing a stock for its potential to go up in price. So new option traders usually start out simply buying call options because it seems similar to what they are used to doing. When a call option on stock is purchased (also called "going long the option"), the call holder is able to control the stock without actually possessing it, and does so for a fraction of the cost.
Buying calls has been one of the most popular strategies with investors since listed options were first introduced. Before moving onto more complicated strategies, an investor should thoroughly understand buying and holding call options.
A long call is a leveraged alternative to the stock itself. As the stock price increases, the option value increases by more (sometimes much more) on a percentage basis. This leverage can result in large percentage profits, because purchasing calls requires lower up-front capital than an outright purchase of the stock. In fact your profits are theoretically unlimited, since there is no limit on how high a stock price can go.
This strategy also has limited risk, since you cannot lose more than you paid for the option. However, while the potential loss is limited in terms of dollars, you can lose 100% of the premium paid for the call. The performance graph below shows the (limited) risk and unlimited potential profit for the long call strategy.
The three lines in the figure above graphically illustrate how time decay affects this position. The dotted line represents the long call's theoretical performance as of today, the solid line represents the performance at expiration (the final day of trading), and the dashed line represents the performance of this option halfway between today and expiration. Notice also that the intersection of each line with the $0 profit line represents that time frame's break-even point; and this break-even point moves farther to the right as time passes.
Which Call Option Should You Buy?
Every stock that trades options has at least four different expiration months with many different strike prices available. Depending on the strike price and time left until expiration, options respond in very different ways to price movements in the stock.
Calls with strike prices higher than the current stock price are called out-of the-money options; if the expiration date were today, they would be worthless. Out-of-the-money options have value only because there is still time left for the stock price to move above the strike price. The part of an option's price attributable to time is called time value or time premium.
An at-the-money call option is one whose strike price is equal to (or in practice, very close to) the stock price. Again, the premium paid for an at-the-money option is entirely due to time. Of course, it won't take much of an increase in the stock price to turn this into an in-the-money option.
An in-the-money call option has a strike price that is lower than the current stock price. The difference between the strike price and current stock price, called its intrinsic value, is the amount the option is in the money. But as long as there is still time left until the expiration day, an in-the-money option will also have some time value as well. That means the price of an option can be broken down into two parts: intrinsic value and time value. Below is a diagram showing how an option's price is broken down between intrinsic value and time premium, depending on whether it is at, in, or out-of-the-money.
The farther out of the money an option is, the cheaper it will be, and the higher the leverage. So if the stock makes a quick move in your favor, an out-of-the-money option will do the best job of multiplying your money. However, if this move does not happen quickly, the out-of-the-money option's performance is likely to disappoint you.
At-the-money and in-the-money options move more like the underlying stock because their delta is greater. The delta of an at-the-money option is typically around .50 – meaning that a one-point move in the stock translates into a half point move for the option. In-the-money options have deltas approaching 1 and they move almost point-for-point with the stock. Often the best balance of factors can be found using at-the-money, or just in-the-money, options.
Long Term Speculation - The Special Case of LEAPS
LEAPS – Long Term Equity AnticiPation Securities – are options that have a far longer life than standard options, with a time frame of years rather than months. Only about 10% of optionable stocks have LEAPS, primarily the most popular high-volume stocks. LEAPS have significant time premium and are more expensive than standard options, but still cheaper than purchasing 100 shares of the stock. In many ways, you can think of them as a substitute for buying the stock.
The primary use of LEAPS is for speculation. As implied by their name, you might purchase a call LEAPS if you anticipate long-term appreciation in the stock price, or a put LEAPS if you think that the stock price is likely to decline over a long period of time. While the risk graph for a long call LEAPS position looks exactly like the long call shown earlier, the longer time period adds some additional risk. In particular, the large time premium associated with LEAPS means they are especially sensitive to changes in implied volatility.
There's no worse feeling than seeing the market move in the anticipated direction, but your options gaining very little. Historical volatility charts, available from the best option-oriented websites and software companies such as OptionVue Systems, can help you determine if a stock's options are cheap or expensive on a historical basis.
There are several reasons to buy call options. Those who would like to participate in movement of the stock price but lack the resources to buy it outright can buy an option for a fraction of the cost. The limited risk appeals to some investors that want to limit their downside to just the price of the option. Finally, there are the people who trade options to take advantage of the leverage available when speculating on price movements.