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Long call stock option trading strategy

 

What is a long call option contract and why should I use it?

 

 

Investors and traders use the long call option trading strategy for different reasons ranging from participating in the increasing of a stock price to protecting an existing short stock position from a potential rally.

 

In this lesson we will be focusing on the pros and cons of purchasing a long call stock option contract. We will also take a brief look at the reasons why a short would benefit from the long call option.

Feel free to view this episode from optionsimple television. Mr. Simple explains what the Long Call option strategy is and why one would use it.

 

 

Also, visit our option definitions page or the optionSimple.com bookstore for help with any terms you do not understand, or to learn more about what we discuss in this section.

 

Call option buying is a popular speculative bullish option trading strategy and may be considered by a bullish investor once consideration has been given to managing the risk of the position.

 

This means that you have a clear understanding as to why you are entering the strategy. You should also have an exit plan in place. You should also be prepared to make any necessary adjustments to the position if need be.

 

The long call stock option strategy is similar to the long stock position.

 

Both strategies are bullish and the investor expects the underlying stock price rise in the long or short term.

 

A major benefit of the long call option position as opposed to buying the underlying stock is with regard to the capital requirement needed to initiate the position.

 

It is also worth noting that when purchasing a long call as opposed to the underlying stock, you don’t actually own anything. This means that you do not have voting rights with a long call option position, because you are not a share holder.

 

As an owner of a long call stock option contract, you only have the right to the buy stock. This allows the owner of a long call option position to participate in a stocks rally for a fraction of the cost that it would take to purchase the underlying stock.

 

Another major difference between buying stock and the long call option strategy is the fact that a long stock position is not subject to an expiration cycle. A long stock position can theoretically be held indefinitely, whereas, all call stock option contracts expire at some point.

 

Before incorporating the long call option strategy into your trading plan, it is extremely important to understand the nature of how a long call option position reacts to time passing.

 

As an option buyer, whether purchasing puts or calls, always scrutinize the price of option contracts, especially cheaply priced options nearing expiration.

 

It is very important to understand that call option contracts are priced the way they are for a reason. Every single day that passes by, call options loose extrinsic value, due to time decay.

 

In the final month (also known as the front month) prior to the expiration of a stock option contract, the contract tends to loose time premium at an accelerated pace (time value measured through the option Greek theta).

Books on the option Greeks and pricing.

 

Out-of-the-money, as well as near-the- money call options may appear to be a great value, but consideration must always be given to the option contracts expiration date.

 

At expiration, a long call option contract is only worth its intrinsic value (true value). This means that all 'out-of-the-money' and 'near-the-money' call options expire worthless.

 

Not to say that purchasing out-of-the-money call options should be avoided completely. There is plenty of opportunity in buying out-of-the-money options. You can essentially control the same amount of shares for a fraction of the cost it would be to actually buy the underlying stock.

 

Someone could potentially make a fortune if he or she owns a lot of cheap out-of-the-money call options and receives the anticipated move in the underlying stock price.

 

Before throwing all of your hard earned trading capital into out-of-the-money call stock options, understand the very real risk that the call option contract can expire worthless, if, at expiration the long option contract is out-of-the-money.

 

Control your risk. Many good traders have lost a ton of money because they had no risk management.

Books on risk management.

 

The volatility of the underlying stock also plays a very important role regarding the long call stock option trading strategy.

 

Any rise in implied volatility levels will have a positive effect on a long call stock option position. Any decrease in implied volatility will almost certainly negatively impact the value of a long call.

 

It is important to understand that implied volatility rises more quickly when there is a sell-off in the underlying stock. Though, it is very possible for the premium of a long call option to increase in value with a sharp move in either direction in the underlying stock price.

 

You will also notice that more volatile stocks have more expensive option prices than less volatile stocks. This is because of higher Implied volatility levels.

 

(Theta and Vega are integral concepts regarding the pricing of call option contracts. They allow you to gauge how much of a stock options premium is due extrinsic value. Time value and implied volatility are a part of an option contracts extrinsic value.)

 

Theta and vega are known as option Greeks. The option Greeks are a set of inputs that an option pricing model, such as the Black-Scholes formula uses to determine a theoretical value for stock option contracts.

 

An understanding of the Greeks is essential to managing risk, as well as understanding why stock option contracts are priced the way that they are.

 

The above option graph illustrates holding a long call stock option position through the option contracts expiration cycle. Remember, at expiration, a long call option contract is only worth its intrinsic value.

 

As an option buyer, you have the right to exit the long option position at any time prior to the option contracts expiration. Many traders choose to do this, especially when there is still significant time premium left in the options price.

 

Another popular method for using a long call option is in combination with a short stock position.

 

When used in this manner, the long call option contract protects the short seller in case of a rally in the underlying stock.

 

Remember, the nature of a long call is having the right to buy the stock at some point in time.

 

If the trader is short the stock, it would make sense that buying a call would serve as good risk management. If a long call is in place, the trader has set a cap on his or her losses if the stock price rises.

 

Books on short selling options and stocks.

 

Many investors who are short stock will consider purchasing a long call option contract prior to an event, such as an earnings report or a broad based announcement that will effect the stock market as a whole. The long call can protect a short seller because these announcements have the potential to cause an increase in the underlying stock position, which could hurt the short seller.

 

As you see there are many advantages to incorporating the long call option strategy into your trading activities. With proper risk management, as well as the ability to make the necessary adjustments, one will be well on their way to trading long call stock option contracts profitably.

 

Feel free to visit the optionSimple.com bookstore for more information regarding the long call option trading strategy. We offer over 1000 different titles on stocks, options, trading, risk management and much more. It pays to know your options!