Stock Option Basics: The Long Call

Trading Options as an income strategy can be very rewarding financially. Like most things, one needs to understand the basics of a financial instrument and become progressively more adept and proficient at utilizing it.

Options strategies are composed of four elements that can be combined in a wide variety of creative ways to limit risk and to generate income. These four basic Option Strategies are: the Long Call, the Short Call, the Long Put, and the Short Put. This article will explain the essential risks and rewards, advantages and disadvantages of the Long Call.

The holder or buyer of a Call Option has the right to buy the stock at the Strike Price at or before its expiration date. The buyer is not required to buy the stock but has the "option" to do so.

The risks associated with the Long Call are the cost of purchasing the Call and any commissions and exchange fees. The Risk Graph below illustrates the risks and rewards:

In this example, the maximum Loss is the $5 we paid for the Call. You can see that the Call is in a deficit position until the Stock Price rises above $70. It crosses the zero line which represents the point where the Call Option moves into positive value. When the Stock Price is above approximately $75, the Call is in the Profit area. At about $80, the Call is worth $5 or is at breakeven. Theoretically, the value of the Call has no limitation on its profitability. If the stock goes up to $125, the Call goes up right along with the stock. The only real limitation on profitability is the expiration date of the Call.

The primary advantages of the Long Call include: capital efficiency and less risk. Capital efficiency involves the reduced capital outlay for an Option than for the Stock. One thousand shares of the stock in our example would cost the trader about $75,000. In contrast, 10 contracts (one contract = 100 shares) at $5 per contract, costs the buyer $5,000. That is a significant reduction in capital outlay.

Risk is maximized at $5,000 for the Call buyer. This risk for the stock purchaser is the entire $75,000. Theoretically, the stock could plunge to zero and the buyer could lose all of his investment. The risk reduction for the Call buyer is enormous.

The principal disadvantages of buying Call Options are time decay and the relative price of the bid/ask spread and commissions to value. Options expire. Options are a wasting asset. If the Stock Price is below the Strike Price of the purchased Call at expiration, the Call will expire worthless. The Call buyer will lose his entire $5,000 investment. A secondary consideration is ratio of the costs associated with trading Options versus stocks. Bid/Ask spreads can be relatively large, such as, $.25 ($.15 X $.40). That means the Call value needs to increase by $.25 to gain back the difference in the spread. Commissions for Options may be relatively greater than for purchasing stock. All these factors need to be considered when purchasing Calls.

Learn how to trade Long Calls effectively for profit by Trading Stock Options the Easy Way.