Benefits, risks and examples of a long call option
A long call option allows investors to benefit from price increases in an underlying asset with limited risk. This article explains the fundamentals of a long call option strategy, its benefits and risks, and how to implement it effectively.
What is a call option?
A call option is a financial contract that gives the holder the right, but not the obligation, to buy a specified quantity of an underlying asset at a predetermined price (the strike price) within a set period. Unlike buying stocks directly, where you pay the full price, a call option requires a smaller initial investment, known as the premium. The premium is paid to the seller (writer) of the call option.
In return the seller of the option has the obligation to deliver, upon the request of the buyer, a specified quantity of an underlying asset at a predetermined price (the strike price). This strategy is known as a short call option.
Both buyers and sellers of call options can terminate either their right or obligation by a reverse (closing) transaction.
Understanding the long call option strategy
A long call option strategy involves purchasing call options with the expectation that the underlying asset's price will rise. This strategy is bullish, meaning it profits when the market goes up. The investor benefits from the potential upside of the stock while limiting their downside risk to the premium paid.
Key components of a long call option
- Premium
The price paid for the option. - Strike price
The predetermined price at which the holder can buy the underlying asset. - Expiry date
The date by which the option must be exercised or will expire worthless.
Advantages of the long call option strategy
- Leverage
Call options provide leverage, allowing investors to control a larger position with a smaller capital outlay compared to buying the stock outright. - Limited risk
The maximum loss is limited to the premium paid, making it a defined-risk strategy. - Flexibility
Investors can choose different strike prices and expiry dates to tailor the strategy to their market outlook and risk tolerance. - Profit potential
Significant profits can be realised if the underlying asset appreciates substantially, offering high reward potential for a relatively low initial investment.
Risks of the long call option strategy
- Time decay
Options are wasting assets, meaning their value erodes over time, especially as the expiry date approaches. This time decay can work against the investor if the expected price movement does not occur quickly enough. - Volatility
While options can benefit from increased volatility, unexpected decreases in volatility can reduce the option's value. - Out-of-the-money risk
If the underlying asset does not rise above the strike price by expiry, the option will expire worthless, resulting in a total loss of the premium paid.
Example of a long call option
Imagine you believe Company XYZ's stock, currently trading at €50, will increase significantly over the next three months. You decide to purchase a call option with a strike price of €55 expiring in three months, costing €2 per share (options typically represent 100 shares, so the total cost would be €200).
Profit and loss potential of a long call
- Breakeven point
The stock price at expiry must exceed the strike price plus the premium paid for the investor to break even. In this example, the breakeven price would be €57 (€55 strike price + €2 premium). - Unlimited upside potential
If the stock price rises above the breakeven point, the profit potential is theoretically unlimited. For example, if XYZ's stock rises to €70, the profit would be (€70 – €55 – €2) x 100 = €1,300. - Limited downside risk
The maximum loss is limited to the premium paid. In this case, the most the investor can lose is €200 if the stock remains below €55 by the expiry date.
Implementing the long call option strategy
- Market analysis
Conduct thorough research and analysis to identify potential stocks or assets expected to increase in value. - Select the strike price and expiry date
Choose a strike price that reflects your market outlook and an expiry date that allows enough time for the expected price movement to occur. - Monitor the position
Regularly review the position and market conditions. Be prepared to adjust the strategy if the underlying asset's price movement or volatility changes significantly. - Exiting the position
Decide in advance your profit targets and loss limits. Consider exiting the position if the stock reaches your target price or if it becomes clear that the expected price movement will not occur within the desired timeframe.
Long call vs. other strategies
A long call option strategy is often compared with other strategies like buying stocks outright, a short put option, or other options strategies like spreads anticipating a market increase.
Versus buying stocks
A long call requires less capital than buying the same amount of stock, offering leverage with limited downside risk. Buying stocks could increase risk potential to such a level that the stocks become worthless. On the other hand, buying stocks does not impose a time limit on the possibility to benefit from your predicted market increase.
Versus a short put option
A short put creates the obligation to buy, upon the request of the buyer of the put option, a specified quantity of an underlying asset at a predetermined price (the strike price). The seller receives a premium as compensation for this obligation. The option loses its value if the price of the underlying goes up. However, the profit for the seller is restricted to the premium received. A short put also requires the buyer to buy the shares at the agreed price, even if the value decreases, or to close out the position against a loss.
Versus spreads
While more complex strategies like bull call spreads involve buying and selling call options at different strike prices, a long call is simpler and offers unlimited upside potential but requires a precise market movement.
Practical tips to increase the possibility for success
- Start small
If you're new to options trading, start with a small position to understand how the market works and gain experience without taking on significant risk. - Use technical analysis
Technical indicators and chart patterns can help identify potential entry and exit points for the strategy. - Stay informed
Keep up with market news, earnings reports, and other factors that can influence the price of the underlying asset. - Risk management
Always be aware of your risk tolerance and never invest more than you can afford to lose. - Diversify
Don't put all your capital into one position. Diversifying your investments can help spread risk and increase the chances of overall success.
The long call option strategy is a powerful tool for investors looking to capitalise on anticipated price increases in an underlying asset while limiting their downside risk. By understanding the key components, advantages, and risks, and by implementing the strategy with careful market analysis and risk management, investors can potentially achieve significant profits. As with any investment strategy, thorough research and prudent decision-making are essential for success in options trading.
Investing in the financial markets requires a deep understanding of various strategies to maximise returns while managing risk. Please consult your bank or broker for advice or read the Key Information Document for the product you are considering investing in to get a better understanding of all risks and costs involved.
See also Options investing e-learning - positions