How to Execute a Long Call Options Strategy: Part 1

LONG CALL PRACTICAL BASICS #1

Now that you have learned the basic academics of the long call, let’s take a look at the application and practical side of the strategy, with some specific examples.

Trading any strategy should involve the development of a set of rules and guidelines that you set out for yourself , a checklist if you will. Rest assured, we will set up a checklist for each strategy we discuss. The aforementioned checklist will make sure that certain parameters exist, parameters that must be met before any trade is made. These parameters, along with a trading plan (which lays out your risk tolerance and money management guidelines) is an essential strategy if you want to take steps toward consistent trading success.

Let’s take a look at the concept of the Call option, which is the most basic and the most common of all options strategies. It is much like a coupon; we will discuss that concept later on.

There are many choices when it comes to buying a call; many different strikes offered, along with many expiration months to choose from. All of these choices could make finding the right option seem like a daunting task for most beginners.

Let’s bring this discussion to layman’s terms, shall we?

Calls are comprised of 2 types of value, intrinsic (or real value) and extrinsic (or time value). How are these values determined? The intrinsic value is determined by the price of the stock, and is all that is left of an option at expiration. The extrinsic value of the option is the eroding value of the option as it approaches expiration, the time value is calculated by a mathematical model, for this example we are not going to focus on how it is calculated, just how much is there.

Let’s say you went to your local gas station to fill your tank for $4.00 per gallon. You walk into the store to pay for your purchase, and the clerk offers you the right to purchase a gallon of gas for a specific price, $3.50 for the coming year this costs you $1.00… some deal, right?

You take the clerk up on the offer and you purchase the call option for $1.00 (for this illustration, let’s call it a voucher). No matter how high, or low (this is key), the per-gallon price of gas fluctuates, you will pay $3.50 per gallon. A day later, Saudi Arabia announces that it will cut production, raising demand – which eventually translates into a per-gallon price of $6.00 for gas.

You are sitting pretty since you have the right to purchase gas for $3.50 per gallon for the next year. If this happens, your voucher is then worth $2.50 – the current gas price less the face value of the voucher.

You could then sell your voucher to someone else, if you were so inclined, at a price better than what you originally paid. Of course, you then transfer your $3.50-per-gallon right to whomever purchases the voucher.

Unfortunately, you aren’t always a winner.  

What if gas supply far outstrips demand? If this happens, the per-gallon price of gas could drop to $1.00 per gallon. What then? Well, you are still going to go to the pump and pay $3.50 per gallon if you use the voucher. Of course, you could always decide to pay $1.00 a gallon and is the most you could lose is the dollar you paid for your voucher. Regardless, your max risk is the dollar you paid for the voucher.

Let’s substitute ABC stock for the voucher. The same concepts apply, ABC stock currently trades at $50.00 per share, and you are thinking about purchasing the Jan 45 call which expires in 180 days and the call is trading at $6.00 (ask price). If the call is trading for $6.00, it can be assumed that $5.00 of that call is intrinsic (or real) value ($50 stock price – $45 strike price)and $1.00 is extrinsic (or time) value ($6 option value-$5 intrinsic value). That $1.00 of time value will decay at a certain rate, which will be discussed later. If the stock rises to $55.00 by its expiration date, it will then have $10.00 of intrinsic value ($55 stock price – $45 strike price). Although we have lost all our time value, the call should be trading for its intrinsic value – or very close to it. If that is the case, we would have realized a 66.5% return (excluding commissions).

The good thing about buying a call is that you can’t lose more than your premium. This fact means that if I paid $6.00 for the 45 call when the stock was at $50.00 and the stock dropped to $10.00, I would lose my $6.00 investment. Of course, this limited loss does not mean that calls are low risk all the time. You still have to be correct in the direction of the stock before the expiration date and manage how many contracts you buy. Try not to think that the more contracts purchased, the better. One thing I want to note is that on expiration, the call will be worth its intrinsic value only. It is a common misnomer that all options are worth nothing at expiration.

So what are the risks? Risks are unique in every situation because every underlying issue is distinct. First, the long call trader needs that stock to move higher than the strike price plus premium paid, or they likely won’t make any money on the trade.

Next – depending on the delta (one of those Greeks we’ll discuss later) the trader purchases – the stock needs to move a certain amount. Finally the trade needs to happen within the option’s lifespan. Because most call buyers have an opinion on which direction the stock is going to move they want to find an option that will not only move when the stock moves, but one that also reduces their risk compared to buying the stock.

Unfortunately, many options traders don’t use advanced Greek analytics, so they need a simpler method of finding the right option to trade. Let’s look at a simple way to analyze an option’s price and a method for choosing an option.

Start off by determining how much of a desired option is time value and how much is intrinsic. Remember, time value is the part of the option that deteriorates throughout the option’s life span. For instance, if the option you select has $2.00 of time value and is already in the money, you know that by expiration you need that stock to move greater than $2.00 from its current point. The key words here are BY EXPIRATION, if you held this option till expiration, you would only be left with intrinsic value. Holding a long call till expiration is not always the best strategy as time value is going away every single day. (explain why it is ‘needed’, because the next two sentences say that you don’t need it to move $2 in order to make a profit). The good news is that you can potentially profit, even if the stock makes a smaller upside move. If the stock makes a move fairly quickly (within a day or so), let’s say it increases $1.00, you may profit from that move because the stock moved faster than the option was losing time value. we will discuss this in our later lessons.