Buy call (Long call)

Why buy a call when you can own the underlying, one may ask. This depends on the intentions and predictions of the holder.

Let’s take for example one long call:

Buy BIDU 1 month  21 call at $0.50

In this example, the trader is bullish on Baidu stock, and believes it will trade at least 5% higher from the current 20$ price, he is however afraid of the downside and risk and wishes to limit his exposure, therefore instead of buying 100 shares at $2000, the trader decides to acquire one call for a total of $50.

If the stock is trading in one month below that strike price of $21, the call will expire worthless, because the holder can purchase the stock at a cheaper price. However, if the stock expires above $21, the holder may exercise his right to purchase the underlying, and the writer is obligated to sell him 100 shares of BIDU for $21. Effectively, the higher the stock, the more the call is worth.

For the stock to be profitable at expiration, the stock must be trading above the break-even price: the sum of the strike price, the price of the call, and the the commission. Not considering the commission, in this case the break-even price would be:

(0.5+21)*100 = $260.

At expiration diagram of long call

At expiration diagram for a long call

Figure 1. Long Call Option

Figure 1 illustrates this with an at expiration diagram, it shows the profit and losses of the position if it is held until expiration. The horizontal axis represents the share’s value, and the vertical axis the profit or loss.

The at expiration diagram of any long call position will always have a hockey stick shape, regardless of the stock price or strike. That is the losses are limited to the price of the contract, and the gains are unlimited when a stock that grows beyond the strike price.

Profits are unlimited if the underlying asset’s price at expiration is above the strike price, however the call will expire worthless if it doesn’t. That is; there’s a tradeoff with a call, where as you can only lose the premium paid, regardless of how low the stock’s value gets. But this benefit of reduced risk is not without a tradeoff, if the stock is only slightly above the strike price at expiration, the call might under perform the stock by the amount of the premium. To be profitable, it needs to be at least higher by as much as the premium.

In a volatile market, a trader may be more inclined to buy a call instead of the stock, for the period of expected volatility, thereby risking less money, until the market settles back down.

If large price movements are anticipated, a trader can also get a much greater exposure to the positive movement by buying more out of the money calls. For example if above the stock reaches $26, the trader reaps a [26-22]/1 = 4 => 400% profit. If BIDU is below the strike price, however he loses the premium.

Most calls represent 100 shares, this leverage accentuates the profits to be made. If for example you only desired to invest $100 on a stock you had a bullish forecast on within a known time, doing so with stocks would expose you to a fraction of the gains that could be made with long calls.

Long calls are for bullish markets, volatility will increase the price of the contract, and so will time value. At expiration the profit or loss is: strike price – exercise price.

Exercise price being the price of the stock when the holder decides to acquire the underlying asset.

You may also be interested in short call position, this is the position an option seller has when he writes a call. You may also use long calls to hedge short positions on  an asset, read about it on the hedging article. And finally, to truly understand the inner workings of a call, make sure to review option greeks.

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