Buying Calls (Long Call Options Strategy)
If you’re looking for a way to potentially profit from a bullish outlook on a particular stock or asset, buying calls may be an attractive option. This options trading strategy allows traders to purchase the right to buy shares of a stock at a predetermined price within a specific time frame. In this article, we’ll discuss what calls are in more detail, take a closer look at the mechanics of buying calls, and explore the potential benefits and drawbacks of this strategy.
What Is a Call?
A call is a type of options contract that gives the holder the right, but not the obligation, to buy a specific underlying asset (such as a stock, commodity, or currency) at a predetermined price (known as the strike price) on or before a specified expiration date. In other words, buying a call gives the holder the opportunity to profit from an increase in the price of the underlying asset.
For example, let’s say that a trader believes that the stock of Company ABC, currently trading at $50 per share, will increase in the near future. The trader buys a call with a strike price of $55 and an expiration date of one month from now. The premium for the call is $2 per share.
If the stock price of Company ABC rises to $60 per share before the expiration date, the trader can exercise the option and buy the stock at the strike price of $55 per share. They can then sell the stock at the market price of $60 per share, realizing a profit of $5 per share ($60 – $55) minus the premium paid for the option, resulting in a net profit of $3 per share ($5 – $2).
However, if the stock price falls below the strike price of $55 per share before the expiration date, the trader may choose not to exercise the option, resulting in a loss of the premium paid for the option.
How to Buy Calls
Firstly, it’s important to note that not all brokers offer options trading. If you’re interested in trading options, you should check with your broker to make sure they offer this service. Some brokers may also require you to meet certain criteria, such as a minimum account balance or level of trading experience, before allowing you to trade options.
Assuming your broker offers options trading and you meet any necessary criteria, here are some steps to follow when buying a call:
- Choose the underlying asset: You can trade options on a variety of underlying assets, including stocks, ETFs, indexes, commodities, and currencies. When selecting an asset, it’s important to consider factors such as volatility, liquidity, and market trends.
- Determine the expiration date: Options contracts have expiration dates, which are typically a few months in the future. You can choose an expiration date based on your trading strategy and market outlook. Longer expiration dates will generally cost more than shorter ones, but can also offer more flexibility.
- Select the strike price: The strike price is the price at which the option can be exercised. When buying a call, you want to select a strike price that is higher than the current market price of the underlying asset. This is because a call gives you the right, but not the obligation, to buy the underlying asset at the strike price. The further the strike price is above the current market price, the more expensive the option will be.
- Evaluate the options chain: The options chain is a table that lists all of the available options for a given underlying asset. When buying a call, you want to look for options with a high delta, which measures the sensitivity of the option price to changes in the underlying asset price. Options with a delta of 0.5 or higher are generally considered to be “in the money” and may be a good choice for buyers. You should also look at the bid-ask spread, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. Narrow bid-ask spreads are generally preferable, as they indicate that the market for the option is more liquid.
- Place your order: Once you have selected the underlying asset, expiration date, strike price, and evaluated the options chain, you can place your order with your broker. Your broker will execute the trade on your behalf and your account will be debited for the premium paid.
In summary, buying a call involves finding a broker that offers options trading, researching the underlying asset, using the options chain to select the best option, and placing your order with your broker.
How to Adjust Long Calls
Adjusting long calls involves modifying your existing call position to manage risk or take advantage of changing market conditions. Here are some possible adjustments you can make:
- Roll forward: If your long call is approaching expiration, you may want to roll it forward to a later expiration date to give yourself more time for the stock to move in your favor. You can do this by selling your current call and buying a new call with a later expiration date.
- Roll up: If the stock price has risen significantly and is close to your strike price, you may want to roll up your long call to a higher strike price. This will give you more upside potential if the stock continues to rise. You can do this by selling your current call and buying a new call with a higher strike price.
- Sell part of your position: If you have a large position in a long call and want to reduce your risk, you can sell some of your calls to take profits and reduce your exposure to the stock.
- Buy a put option: If the stock price has started to fall and you are concerned about losing money, you can buy a put option as a hedge. This will allow you to sell the stock at a predetermined price if it falls below a certain level.
- Close your position: If the stock price has not moved in your favor and you don’t see any potential for a profit, you may want to close your long call position to limit your losses. You can do this by selling your calls.
It’s important to note that adjusting your long call position involves additional transaction costs and risks, so it’s important to weigh the potential benefits against the costs before making any adjustments.
Pros and Cons of Buying Calls
Buying calls can be an effective strategy in some situations, but it also has its potential drawbacks. Here are some of the pros and cons of buying calls:
- Limited risk: When you buy a call, your potential loss is limited to the premium paid for the option.
- Leverage: Calls provide a way to control a larger position in the underlying asset with a smaller investment, which can amplify gains if the underlying asset’s price moves in your favor.
- Potential for unlimited profit: When you buy a call, your potential profit is theoretically unlimited as the underlying asset’s price can rise indefinitely.
- Limited lifespan: Calls have a limited lifespan and will expire worthless if the underlying asset’s price does not rise above the strike price before the expiration date.
- Time decay: The value of a call decreases as the expiration date approaches, even if the underlying asset’s price remains stable or increases.
- Volatility risk: Calls can be highly sensitive to changes in volatility, which can affect the option’s price.
- Requires skill and knowledge: Buying calls requires a good understanding of the underlying asset, market conditions, and option pricing, which may be difficult for inexperienced traders and investors.
Overall, it’s important to understand the risks and potential rewards of buying calls before making any trading decisions.
The Bottom Line
In conclusion, buying calls can be a potentially lucrative strategy for those who are willing to take on some risk. By purchasing the right to buy a stock at a set price, traders can potentially profit from a rise in the stock’s value while limiting their downside risk to the cost of the option premium.
However, it is important for traders to do their research and carefully consider their goals and risk tolerance before buying calls. They should also be aware of the various factors that can impact the value of their options, such as changes in the stock price, volatility, and time decay.
Ultimately, buying calls can be a useful tool for traders looking to generate returns in a bullish market, but it should be done as part of a well-diversified portfolio and with a clear understanding of the risks involved.