Long Calls

Call buying is the simplest form of option investment, and therefore, is the most popular option strategy.

The success of this strategy depends primarily on the investor’s ability to:

1) select a stock that will advance in price,

2) select an expiration month that insures the expected advance will occur before the option expires, and

3) select a strike price so that the potential benefits of the advance are balanced with the possibility of losing the entire premium paid.

Opinion: Bullish to very bullish.

Example: Long 5 XYZ Oct 60 Calls.

Description: Call buying is a strategy used if the investor thinks that XYZ will advance in price. It is important, given the risk, that the investor have a clear idea about where the stock is going and when. Simply thinking XYZ is a “great company that is sure to go up” is not enough. A Call purchase based on such vague notions is likely to cause frustration as losses mount when the advance fails to materialize.

Buying Calls: Why?

For the most part, there are two types of Call buyers:

the bullish speculators wanting to take advantage of the leverage options can offer, and the investor buying a Call as a substitute for buying the stock.

The Speculator:

The speculative Call buyer uses options for their leverage.

For example, by buying a Call, the investor gains the upside potential of 100 shares of XYZ while at the same time investing a much smaller amount of the captal than required to buy 100 shares of XYZ stock.

100 Shares XYZ * $60 = $6,000.00 vs. 1 Oct 60 Call @ 4 7/8 = $487.50

This lower capital commitment allows the investor to do two things:

1) Potentially realize large % gains from a modest advance in XYZ.

Note of caution: With a $4 advance in XYZ, a Call might climb to 4 1/2 from its purchase price of 3 (a 50% gain). But, leverage is a “double-edged sword.” A decline in XYZ can result in large % losses (up to 100%). Thus, the cost for more reward is more risk!

2) The other benefit of a lower capital commitment is QUANTITY – the ability to buy more Calls, thereby “controlling” more XYZ stock!

Important note of caution: Buying more Calls because they cost less than buying shares of stock is a dangerous way to trade options. The profits will be greater of right, but the investor can lose most, if not all, of the initial investment if XYZ does not advance beyond the break-even point.

The Call-buying Stock Investor:

Some investors purchase Call options in lieu of buying stock.

For example, an investor who is ready to buy 500 shares of XYZ at $60 – but instead spends @2 437.50 for 5 ATM XYZ Calls – is not speculating. An investment decision is being made to use Call options instead of putting $30,000 of investment capital at risk.

500 Shares XYZ * $60 = $30,000.00 or 5 Oct 60 Call @ 4 7/8 = $2 437.50

By definition, a Call option gives the owner the right to buy XYZ at the strike price up until the option’s expiration. Therefore, by purchasing Call options, the investor is able to:

• establish a bullish position which will benefit from an increase in XYZ,
• retain the ability to actually buy XYZ stock for some period of time into the future, and
• insure that the remaining capital is protected from any decline in XYZ.

The Call buyer’s loss is limited to the premium paid for the Call option, while the stock buyer’s entire investment is very much at risk! Thus, the premium spent on the Call option can be viewed as the price that must be paid to insure a limited loss of capital in the event that XYZ declines instead of rallying.

The Call’s time value is the cost of the insurance policy. The buyer accepts the trade-off: less reward ix XYZ rallies for less risk if XYZ declines.

The Call buyer understands that the writer of a Call option is saying, in effect, to the buyer, “If, for the next 103 days until October expiration you don’t want to lose money from a direct investment in XYZ should it go down, and still participate if it goes up, you are going to have to compensate me for assuming this risk instead of you.”

The Bottom Line:

Call buying offers the bullish investor two advantages:

• unlimited profit potential, and
• limited downside risk.
• No other options strategy offers the investor as much leveraged upside potential in a rising market. The total amount at risk is always the premium paid for the options.

However, selecting the right strike price on the right stock at the right time is critical for the Call-buying investor.

The biggest difference between the “speculative” and the “insurance” Call buyer is in the answer to the question, “How many Calls do I buy?”

Remember, the Call buyer who is buying Calls in lieu of a much larger investment in the actual stock of XYZ is substituting the shares represented by the Call options for the actual XYZ shares he or she wants to buy. Thus, the investor buys one Call for each 100 shares, no matter which strike price is selected for purchase.

Select Month & Strike best suited for particular opinion:

The investor needs to build an understanding of the trade-offs that are part of the selection process.

For example, a(n) August 60 Call costs less than a(n) January 60 Call. A 60 strike Call in October costs more than the 60 Call. Does the investor want to spend the additional money for the additional time or the lower strike price?

Trade-offs:

The selection process is full of choices. With four different expiration months and three, four, five or more different strike prices for each month, the investor is confronted with a long list of possible Call options to buy. Understanding the trade-offs involved in selecting and buying Call options is important.

It is important to note that while Call buying is a strategy in and of itself, it is also a building block used in constructing more complex strategies.

Timing & Distance:

As a starting point, the investor should focus on the opinion that prompted the idea of buying XYZ Calls in the first place.

In so doing, ask “What is the timing and magnitude of the anticipated rise in XYZ?”

In this regard, Call buying is similar to planning a trip – “How far am I going and how long is it going to take to get there?”

Trade-off #1: Oh, if only I had more

Time is like fuel! In order to make your final destination, you will need to have purchased an ample supply of fuel.

Realizing that there are no refueling stations along the way, at which one could “pick up more time,” the investor must make sure to select a Call option with enough time until expiration.

When buying Calls, running out of time can be costly! The problem every investor faces is deciding what qualifies as enough fuel!