Long Call Option Strategy
A call option gives the buyer the right to buy 100 shares of a stock at the strike price of the option, on or before its expiration date. If the market price of the underlying stock exceeds the strike price in that timeframe, the option can be exercised to buy the stock at lower-than-market price.
In this way purchasing a call option allows you to benefit from the upside movement of a stock without the downside risk of holding that stock long in your portfolio. The call option gives you flexibility to buy the stock at a favorable price if it appreciates, while not requiring you to hold it long in the meantime. In exchange for this protection from downside risk, you pay a premium to buy a call option, which gives you the right to purchase 100 shares of stock.
A long call option strategy involves purchasing a call option by itself. Investors who expect the underlying stock to increase in value may buy a call option without ever intending to exercise it and buy the shares. The call itself will gain value as the underlying stock price increases, and the call can be sold back for a higher premium than it was purchased for. Investors seeking growth or speculating on the market use the long call option strategy for its potential to generate short term gains.
There’s theoretically infinite upside potential in purchasing a long call option, but an investor stands to lose the entire amount of the premium paid to open the long call option strategy if the underlying stock underperforms.
For this reason, the long call option strategy requires a considerable level of risk tolerance.
Let’s See an Example:
Suppose a friend of yours tells you about an up-and-coming software technology company that trades under the ticker IOIO. She says that with the recent release of their new proprietary coding software, the stock should double within the next 3 months. You understand that technology companies are risky investments but that by buying a call you could benefit from the upside without having to buy the stock from the onset.
IOIO trades at $10 while a 3 month call option with the $10 strike price trades at $2.
You buy one IOIO call option at the $10 strike price with 3 months until the expiration date for a premium of $2.
Since option contracts cover 100 shares, the total cost is $200.
For the next three months, the stock rallies all the way up to $18. Just before the option’s expiration date, you decide to exercise the right to buy the stock at $10. You pay $1,000 for the stocks, which are now worth $1,800. In total you have an unrealized profit of $600 on the stock which you were able to lock in by only paying $200 for the option.
Let’s analyze the Potential Profit and Loss Pay Off of the Long Call Option
The maximum potential profit is theoretically infinite since the price in theory could continue to rise to any level. This is calculated as follows:
Maximum Profit per Option = (Theoretical Infinite Price – Call Option Strike Price - Premium) x 100 shares
$∞ = ($∞- $10 - $2) x 100 shares
The maximum potential loss is the $2 premium paid for the call option multiplied by 100 shares. This is calculated as follows:
Maximum Loss per Option = Premium Paid x 100 shares
$200 = $2 x 100 shares
The break-even point is the $10 strike price of the option plus the $2 price of the premium paid. This is calculated as follows:
Break Even Point = Strike Price + Premium Paid
$12 = $10 + $2
When the stock trades above the $12 per share breakeven point, your call option is profitable.
The profit and loss of the long call option strategy is depicted in the chart below.
The chart shows the potential profit and loss on the y-axis versus the corresponding stock price in the x-axis until expiration date.
The breakeven point is $12 which is the strike price of $10 plus the premium paid of $2. If IOIO trades up to $12 and beyond the long call will be profitable, as indicated by the green shaded region. At $13, you have a gain of $1 per share. At $22, you have a gain of $10 per share, etc. Theoretically, a long call option has infinite profit potential as the price can reach any level.
Conversely, when the stock trades below the $12 per share breakeven point, you begin to see losses. At $11, you’ve only recouped half of the $2 per share premium. At $10.50, you’ve recouped only a quarter of it. At $10 and below, you lose the entire premium. The maximum potential loss is the premium paid for the call option, which in this example is $200. This is indicated by the red shaded region of the graph. If the price of IOIO were to remain below the breakeven point of $12 by expiration date, all chance of a rebound will be gone and the $200 loss would be realized.
If IOIO is above $10 and you have enough equity to exercise the call option, you can purchase 100 shares of IOIO for $10 a share. On the expiration date, if the price is above $10, and there is enough equity in your account to exercise the call option, it will be automatically exercised, resulting in 100 shares long of IOIO at $10 as of the next trading day.
If you don’t want to purchase shares of IOIO or don’t have enough equity to purchase the shares, you can instead sell the call option on the open market before expiration. For example, if the price of IOIO goes up to $18 from $10, the call that you paid $2 for may now be worth $9, resulting in a $700 profit on a $200 investment. That’s a 350% return on investment! If you had invested the same $200 in buying the IOIO stock at $10 and selling it at $18, you would only profit $160, or 80% from your initial investment. You can see the powerful leverage effect that buying a call option has compared to buying the actual stock position.
Like any investment, call options are not without risks. But with careful research and attention to those risks, you may find that they fit your investment strategy.
*The tickers are fictitious and are only intended to illustrate examples of complex option strategies.
All prices used in the examples are not representative of actual prices options can be worth at any time.
