Last Update: August 2021
We’ve talked about hedging, backtesting, and volatility among other things. Now it’s time for a rundown of the basic strategies that comprise the options market. Today kicks off the first in a multi-part series on options strategies.
The long call is a seductive chap. There he sits, beckoning to the speculator with promises of unlimited upside. With infinity on your side, you can capitalize on uptrends just like Buzz Lightyear. Or so he says. While the long call does boast advantages aplenty, you mustn’t forget its dark side.
Buying a call is the first strategy most stock traders learn upon venturing into the world of derivatives. And for a good reason. They’re similar to long stock and are simple to wrap your head around. When you buy a call option, you have the right to purchase stock at a set price for a specified period. Let’s say a stock is trading for $100 and you buy a call granting you the right to buy it at $95 for the next three months. If the stock proceeds to rise toward $105, $110, $115 and beyond, then your call option will increase in value. The reason is simple. You can buy the stock that is now trading for $115 at a mere $95. That’s a hefty discount!
If the stock falls, then your call option will fall in value as well. Possessing the right to buy a stock at $95 isn’t attractive if the share price is falling towards $90, $85, and lower.
Takeaway #1: Long calls are bullish and rise in value as the stock rises.
As mentioned above the potential profit for a long call is unlimited. In that sense it’s the same as a long stock position. But here’s where things get exciting. Whereas with stock you continue to lose money if prices fall, with a call option your risk is capped at the initial purchase price. Check out the following comparison on shares of Apple:
- $AAPL Shares
- Long 100 shares @ $169.32
- Cost: $16,932
- Max Risk: $16,932
- Max Reward: Unlimited
- $AAPL Long Calls
- Long 1 two-month $170 call option
- Cost: $700
- Max Risk: $700
- Max Reward Unlimited
As you can see we’re acquiring the same potential upside for a pittance of the cost. This highlights the first two advantages of the long call – low cost and limited risk. And since you can acquire exposure to all the upside in AAPL stock (at least for the next two months) for such a small cost, the trade is highly leveraged. That’s the third pro for the strategy.
Takeaway #2: Long calls provide a lower cost, limited risk, and more leveraged alternative to long stock.
One of the best ways to visualize how a long call improves upon a stock position is to compare their risk graphs. As shown below the long stock appears a 45-degree angle from left to right. No matter how low the stock goes, your losses continue to mount. In contrast, the long call graph is a hockey stick showing similar upside but limited downside.
Were we to end the story there it would be one of the happily ever after variety. Long calls would be a slam dunk alternative to buying stock. But, as I said, there is a dark side. And it’s one that makes profiting from long calls very tricky. Or, at least, trickier than most people think.
The principle difference between the behavior of stock and options comes down to time decay. When you buy a call option, part of what you pay is attributed to time. It’s known as “time value” or “extrinsic value” and is directly linked to the amount of time remaining in the contract. Options are decaying assets and lose a little bit of time value each day. To offset this time decay loss, the underlying stock has to rise over the duration of the trade just to breakeven.
With a long call, you don’t just make money when the stock rises. You make money if the stock rises far enough, fast enough. If the stock rises, but not far enough then you lose money. If the stock rises far enough, but not fast enough then you lose money. This “time decay difference” is illustrated in the risk graph below. Because of this time value component the long call makes less money than long stock regardless of how high the price rises. Worse yet, there is an entire section where the long call generates a loss when long stock would have broke even or created a modest gain.
This, friends, is the rub with long calls. To make money with them consistently requires impeccable timing and a high win rate. These are skills that few have. And that is why most traders gravitate towards strategies that are more forgiving and provide wider profit ranges.
My goal isn’t to dissuade you from trading calls. Rather, it’s to highlight its pros and cons so you can make a more informed decision. If the strategy intrigues you then, by all means, trade away 🙂
Options Trading for Beginners
Continue learning the basics of Options trading with this additional freemium content from Tackle Trading.
Options 101 [Free Content]
Access more free high-quality articles to improve your knowledge of Options Trading.
In this article, Gino Poore delivers a great lesson on understanding and using the Delta of an option.
In this tutorial video, Coach T shows how to manage a credit spread and how to set up a contingency in ThinkOrSwim.
In this Thinkorswim tutorial video, Coach T walks the team through how to use the risk graph for options trading.
In this video tutorial, Coach T walks the team through how to set a basic stop on a covered call or naked put position.
In this video tutorial, Coach Matt goes through the latest edition of the Options Research Spreadsheet explaining how to use it to find the best stocks to cash flow.
In this video, Tackle Trading’s Coach Tim explains when, how, and why a trader would buy a put option on a covered call position.
The Tackle 25 2016 Edition is up and better than ever. This list contains the best stocks to cash flow and compound your gains.
The assignment hobgoblin has been haunting the dreams of novice traders since the dawn of the options market.
In this video tutorial, Coach Tim Justice teaches how to find the best candidates to trade the Covered Call options strategy using the Theta Research tool.
The Tackle 25 2017 Edition is up and better than ever. This list contains the best stocks to cash flow and compound your gains.
What is the Black-Scholes Model and how to use it in your trading? This is what this video will cover.
Delta measures the probability of an option expiring in-the-money.
The Options Heuristic Series [Free Content]
How can we explain the basics of Options so that our students can really learn, without getting confused with so many concepts, terminologies, and strategies? That’s the idea behind the series.
Options Greeks Guide [Free Content]
The Options Greek Guide is a simple, powerful resource to help you better understand how to use the Greek’s.
As you build, enter, and manage Options Trades, it’s helpful to understand the math behind the Black Scholes Option Pricing Model. Using the Options Greek Guide will give you the information and training on how time, volatility and asset price changes impact options values.
What are the Options Greeks and how can you utilize them in your trading routine in order to perform better in the market? This is what you will be learning in this video series.
What is the Black-Scholes Model and how to use it in your trading? This is what this video will cover.
Options 101 Course [Premium Content]
The Options 101 Course is exclusive to PRO members. Try it for free for 15 days by clicking on the button below.
Options Report [Premium Content]
The Options Report is a weekly briefing delivered to Pro members of Tackle Trading. In this report, you will receive information and education that will help you develop as a trader. We will also highlight attractive trade setups for the coming week that you can add to your watchlist.
Financial freedom is a journey
Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.
Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.
All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.