Buying Calls

The long call strategy provides unlimited profit potential with limited risk. It is best used in a bullish market where a rise in the price of the underlying asset above the breakeven is anticipated. Zero margin borrowing is allowed. That means that you don't have to hold any margin in your account to place the trade. You only pay the option's premium-a fairly small investment depending on the market you choose to trade.

Let's review an example of a long call strategy using eBay, Inc. (EBAY). The stock is currently trading at 25.29 and the October 25 strike price call has an asking price of $2.00. Figure 1-A shows the risk graph for this basic option strategy; note how the maximum loss is represented by a horizontal line. This example uses an ATM option worth +50 deltas.

This option price is $2 for a total cost of $200 (2 x 100 = $200) plus commissions. The maximum risk is the price of the option ($200). The maximum reward is unlimited to the upside as eBay Inc. stock continues to rise. The breakeven is calculated by adding the strike price (25) to the premium of the call option (2). In this example, the breakeven is 27 (25 + 2 = 27). This means that the trade starts to make money when eBay rises above 27.

In addition, notice that the risk graph's profit and loss line slopes up from left to right. This represents the trade at expiration. Look to where it crosses the breakeven point at 27 and continues to rise above this point.

To exit a long call, you have three options. You can let the call expire and lose the premium if it is less than $0.25 (not exactly my first choice). You can exercise the call to receive the underlying stock at the strike price of the option; or you can sell the call. By exercising the call option, you can make money by turning around and selling the stock at the current market price and pocketing the difference. By selling the call, you can make money when the price of the premium rises in value due to a rise in the underlying stock.

By choosing to purchase this long call option, instead of 100 shares of eBay stock, you have increased your leverage and reduced the risk inherent in the trade. A long call option uses less initial outlay of cash to participate in the trade. In addition, the most you can lose by purchasing a call is the price of the premium or $200. The most you can lose if your purchase the stock outright is $2,529-the full amount paid for the stock. However, the $200 option still allows you to control $2,529 worth of eBay shares. This kind of leverage is what makes options so appealing.

LONG CALL EXAMPLE SPECIFICS

Long 1 OCT EBAY 25 Call @ 2
EBAY @ 25.29
Net Debit: 2 or $200 (2 x 100 = $200)
Maximum Risk: $200 (2 x 100 = $200)
Maximum Profit: Unlimited to the upside beyond the breakeven
Breakeven: 27 (25 + 2 = 27)
Margin: None

Related Articles:

• When to Avoid Buying Calls

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