Long Call Strategy

 

“The Long call is a limited risk/unlimited reward play”

 

Overview/General Remarks

The long call option is the sexiest of all options trades. It’s easy for new traders to be seduced by the limited risk/unlimited reward potential. But don’t be fooled so easily!

Price doesn’t tend to move very far in one direction or another without a catalyst.

There are however many potential catalysts; strong earnings, increasing demand, mergers, acquisitions, jobs reports, etc. that can drive prices higher (or lower). They just don’t happen quickly enough to be very successful with long options alone.

 

Sum it up: In order for a long call to become profitable something must spark a wave of buying in a short period of time. That can absolutely happen, I’m not saying it can’t or that it won’t. I’m just saying the probability is relatively low, then add in the low probability of making an accurate directional prediction and you’ll see why this strategy can be so difficult to master.

 

Expectations

Employ this strategy with the expectation that share price will move higher immediately.

 

Setup/Construction

Buy a call option at any desired strike. Many believe that to be successful with long call(put) options purchasing ITM strikes is the safest bet. I’m on the fence about that due to the higher cost of ITM options(greater risk).

 

Example Long Call

 

Notice in the image above where the blue line intersects the zero (0) line. Anything above that zero (0) line represents the profit potential for this strategy. Notice the unlimited profit potential for the long call strategy? Certainly appealing but very, very misleading.

The horizontal line below the zero (0) line represents the maximum loss for this strategy or the premium paid to enter the position. Cannot lose more than was paid to enter the trade.

 

Example trade on SPY. Click to Enlarge.

 

Max Reward/Loss

Reward = theoretically unlimited (price will have to skyrocket fast however)

Loss = limited to the debit paid to enter

 

Price Assumptions

Price will increase substantially in a relatively short period of time.

Given this assumption it would make sense to purchase a long call option. Thus, utilizing options leverage and avoiding the margin requirements or substantial risk associated with actually owning the shares.

 

Leverage

Suppose the share price rose $1 to $219.46. The result would be a $100 dollar gain, or less than a 1% return from owning the shares outright. That initial hundred shares would have cost $21,846!!

That same move for the $219 strike option contract would have yielded, all things constant, ~$58 dollar gain or ~27%! Pretty incredible difference percentagly 😉 speaking.

For the example above, I’ve purchased the option for $215 ($2.15 premium x 100 shares) as opposed to paying $21,846 for the 100 shares ($218.46 per share x 100).

Effectively, a long call option minimizes total capital at risk and can offer much higher percentage gains.

 

Pros/Cons of the Long Call

Pros

• Limited risk
• Unlimited reward
• Easy to enter/exit
• Easy to adjust

Cons

• Low rate of success
• Time decay
• Wild P/L from day to day.

 

“The Greeks”

The Greeks help traders understand the forces affecting the prices of options contracts. They are always changing, every minute of every day, so it’s always good practice to stay abreast of their current values and how they might affect a position at any given time. For Definitions of each of the “greeks” presented below visit the Terminology page.

 

Delta

In this example, I’m trading an At-the-Money (ATM) option with a delta of .45 or just 45. This means, at this exact moment if price were to jump $1 higher I would make .45c or, multiplied by hundred to account for our right to control 100 shares, $45 dollars.

 

Gamma

The example here shows a gamma of .06 or 6. If SPY moves up by $1 gamma suggests the new delta would be 51. Showing that each favorable price move will increase the rate at which profit is acquired.

 

Theta

This example shows a theta of -.03 which indicates that with each day that passes I’ll lose .03 cents, or multiplied by 100 to account for the right to control 100 shares, $3 per day.

 

Vega

This example suggests a vega of .27 or 27 and an implied volatility of 12.91%. Therefore, it is believed that if volatility increases to 13.91% I’ll realize a .27 cent increase in option price.

 

“Greeky” Things

Keep in mind when considering the greeks they’re theoretical in nature and often theory and reality don’t mesh perfectly. But I’ll leave it to you to determine what opinion you have on the matter.

The real power of the greeks comes when applied to an entire portfolio. Basically, you’ll be able to use these 4 values to understand your overall portfolio and which market effects help or hurt without having to study each individual position. Pretty awesome in that regard.

 

Summing up “the Greeks”

Lets bring all of these into one basket to consider their effect on this example long call trade. Let’s recap the above;

– Delta = +45 – Gain or lose .45 for a 1$ change in price.

– Gamma = 6 – Gain or lose 6 deltas for 1$ change in price.

– Theta = -3 – Lose .03 per day.

– Vega = 27 – Gain or lose .27 for a 1% change in Impllied Volatility.

– Current IV = 12.91%

 

The greeks are nice because they aren’t describing what might happen or what could happen. They’re saying this is what it is, at this moment in time, in these market conditions.

 

Implied Volatility

Simply, when volatility is high then option premiums are considered to be “inflated”. If IV is low the premiums are considered to be “deflated”.

 

“When volatility is high, option premiums are relatively more expensive, when volatility is low, option premiums are relatively cheaper.”

 

For this example, IV is relatively low at approximately 13%. The lowest it could be is 0% and the highest is 100% so taking this into consideration if an increase in volatility does materialize over the next 33 days, inflated premiums will result.

CAUTION – while that may sound well and good, typically volatility increases when price declines, hurting a long call option position. If it’s believed prices will move lower a long put option would be a favorable position. In which case, the benefit would be twice as nice, profit would be realized on the decline itself as well as premium inflation.

 

Liquidity

NEVER trade in illiquid markets. Liquidity can be determined by viewing the open interest and volume for a particular asset. As depicted, SPY has plenty of open interest and volume to support trading that market.

An easy way to view liquidity is to look at the bid/ask spread. Anything more than 5 cents wide is bordering illiquid, in my opinion. I would always check open interest and volume before placing a trade as well.

 

Probability ITM/OTM

For the long call strategy I would like to see the $219 strike call finish in the money or at least move into the money so I may sell it back to the market at an increased price. The probability of being ITM for this option is 44%

 

Click to Enlarge.

Commissions

Commissions won’t be discussed at length on this site as they vary across brokers and individuals dramatically. TD Ameritrade is my preferred broker and they have a comparative commission structure. They may be a little higher but I’m happy with the thinkorswim platform, so I willingly pay for that access.

 

Final Thoughts

I’ll wrap up this example by explaining how I might assess this particular long call option trade (or any trade).

I’d get a piece of paper and draw a line down the middle. One side would represent the pros. The other, any cons for that trade. Also keep in mind, (not shown here) I would include any assumptions made via technical indicators, current events, earnings reports, etc. to compile the total outlook for the position.

All in an effort to bring everything onto one sheet of paper. A decision is easier and it helps to keep a detailed log of my trades and rationale.

 

For example;

Pros

– Moving average above 200 SMA (not shown here)

– PPS indication (not show here)

– Price increase expected immediately.

– Expected volatility increase

– Liquid

– Positive jobs report

– Etc.

 

Cons

– % B overbought (not shown here)

– Price at all time high could signal reversal soon

– Prob. ITM of 44%

 

Since the Pros outweigh the cons in this case, I would enter the trade.

I would immediately identify and initiate my stop and profit targets and enter those orders with a one cancels other (OCO) stop limit order. This way, no matter what happens I know I’ll either hit my profit goal or my stop target and all emotion will be left out of the equation.

Well, that’s about it. I know that was a lot to digest for what seems like such a simple and straight forward strategy. But I can assure you the Long Call is anything but simple and straightforward.

I hope you were able to benefit in some way from the material provided. If not or if you have a question please leave a comment below or send me a message via the contact page and I’ll be in touch very quickly.

 

Disclaimer

U.S. Government Required Disclaimer: Options trading products, services, and information are for educational purposes only. All information shared is confidential and proprietary. Your success with this content is entirely dependent upon your actions. You are required to do you own research and due diligence. Options trading products and training programs are for educational purposes only, and are provided with the understanding that I’m not a registered investment adviser and nothing herein shall be construed as a solicitation and/or recommendation to buy, sell, or hold any financial instruments.

Recognize that the purchase of, sale of, or giving of advice regarding foreign currencies, commodities, stocks, options or futures can only be performed by a licensed, registered or exempt person. Understand that I do not solicit or execute trades or give investment advice, I am not registered as a broker or adviser with any federal or state agency, and encourage consultation with a licensed representative or registered investment professional prior to making any particular investment or using any investment strategy. Stock and options trading has large potential rewards but also involves large potential risks, and that as an investor, you should only use and/or risk capital you are prepared to lose.

This program is intended solely for the avocation, personal enrichment, and enjoyment of students. Your success depends on your unique skills, time commitment, and individual effort. Recognize that neither unique experiences, past performances, historical tests, nor included or accessible strategies, scans, or patterns constitute recommendations or guarantee future results. You are solely responsible for the selection of your own stocks, currencies, options, commodities, futures contracts, strategies, and scans, and monitoring your brokerage account(s), the programs and anything, including, without limitation, delays or outages of any type, which may adversely affect you.