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Options Theory: Long Calls

December 10, 2017

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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.

Time Decay

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.

Long Call risk graph. Time decay difference.

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 🙂


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