Long call option: what it is and how to use it in trading

A long call option earns investors a profit after an increase in the price of an asset with minimal risk involved. In this article, we explain the basic fundamentals of a long call, how to trade it, its advantages and disadvantages, and how an investor can increase profitability using this instrument.

What is a long call option?

A call option is a financial contract that, when executed, gives an investor or holder the right, not the obligation, to buy an asset at the predetermined future price or the strike price within a certain period. Underlying assets can be diverse, including stocks, commodities, bonds, currencies, indices, and others.

Unlike normal stocks or shares, where an investor must pay the full amount upfront, a call option only requires a small initial payment. For example, if you want to buy 100 shares of a stock priced at $50 per share, you would need to pay $5,000.

In contrast, buying a call option requires paying only a small fraction of the underlying asset's value, known as the premium. For instance, if the premium for a call option on that same stock is $2 per share, you would pay $200 for the right to buy 100 shares at the strike price.

This initial amount goes to the seller of the call option. Subsequently, the seller is required to deliver if the buyer requests it. The strategy is called the short call option. Also, note that both parties may opt to terminate the contract.

A long call option refers explicitly to the position of the buyer of the call option. When investors purchase a call option, they are said to have a 'long' position. This is a bullish strategy, as the buyer profits if the underlying asset price rises above the strike price plus the premium paid for the option.

Key components of a long call option

The key components of a long call are:

• Premium is the price paid by the buyer to purchase the call option. This is the maximum potential loss for the investor if the option expires worthless.
• Strike price is the predetermined price at which the holder has the right to buy the underlying asset. It is fixed when the option is purchased and is crucial for determining profitability.
• Expiry date is the specific date on which the contract must be exercised or expire at a loss. After this date, the option ceases to exist.

Additional essential concepts related to a long call option include:

• Breakeven point—this is the stock price you need to reach just to cover your costs. For a call option, that means: strike price + premium paid. You only make a profit if the stock goes higher than this.
• Profit potential—this is how much money you could make. With a call option, the higher the stock goes above the strike price, the more you earn.
• Risk—this is the most you can lose. For a long call, it's limited to the premium you paid. Even if the stock crashes, you won't lose more than that.
• Time decay means your option loses value as the expiration date approaches. If the stock doesn't move in your favour quickly enough, the option can become worthless, even if the price eventually rises.
• Volatility impact—this refers to how much the stock price moves around. More volatility usually makes your call option more valuable, increasing the chance of a big move above the strike price.

Advantages

Leverage. One advantage of call options is that they allow investors to control large contract values with just a small initial capital, making them lucrative as they can make huge profits from leverage.

Limited risk. The call option has a defined risk-to-reward ratio, which helps buyers control the possibility of loss.

Flexibility. In option trading, investors are in a position to select various expiration prices for the contract. Thus, an investor can tailor their strategy to meet the market outlook anytime.

Profit potential. If an investor has made a correct decision, they can gain significant profits, especially in cases of high volatility where the underlying asset appreciates substantially.

Disadvantages

In some cases, the contract may result in a full loss of the initial amount of premium paid.

Compared with other assets, such as currencies, the option does not yield a one-for-one profit with the underlying. In some cases, the underlying asset may only yield $0.7 for a $1 move because of the delta.

Delta is a key number in options trading. It tells you how much an option's price changes when the underlying asset, like a stock, moves by $1. It shows how sensitive the option is to price movements.

• Delta ranges between 0 and 1 for call options.
• Higher delta means the option is more sensitive to the stock’s price changes.
• Lower delta means the option moves less when the stock does.

For example, if a call option has a delta of 0.2 and the stock goes up by $1, the option's price should rise by about $0.20.

Delta changes over time. Early in the option's life, or when the option is far out-of-the-money, delta tends to be low because the chance of the option becoming profitable is smaller.

Long call vs. other strategies

Here, we'll explain the differences between the call option and other trading strategies.

Long call option vs. buying stocks. Investors require less capital to initiate a long-call contract than to buy stock or shares. This reduces the risk involved in cases where the contract does not profit. Moreover, an investor trading in the stock market or investing in shares is not bound by time, as in the case of option trading.

Long call option vs. short call option. Short put options allow investors to buy the underlying asset at a certain agreed-upon price (strike price). Similarly, sellers get a premium as compensation for the obligation. The option expires or loses its value if the price exceeds the strike price. However, an investor must understand that the seller's profit is restricted to the agreed-upon initial payment.

Examples

The diagram below explains the long call option. First, investors should note that the maximum risk is capped at the option's cost. Thus, the potential gain and profit potential are unlimited.

Second, for an investor to make money, the underlying stock price should be higher than the strike price at the expiration point.

In the example below, a long call option with a strike price of $100 purchased for $5 has a potential loss of $500 and unlimited gain only if the price continues to rise. It is essential to understand that the underlying price must be higher than $105 at expiration for the investor to make money.

How to use the long call option

Using a long call option involves buying a call option when you expect the price of the underlying asset to rise. Here's how to use this strategy effectively:

1. Perform market analysis. Before making any investment, you need to conduct thorough research on the market to identify assets that have the potential to appreciate in value.
2. Select the strike price and the expiry date. After picking your preferred asset, select the strike price. It must be a representation of your market direction. Then, choose the expiry date when you expect to close the contract.
3. Monitor the positions regularly. Market conditions keep changing, so frequent review ensures you adjust your strategy based on volatility and price movement. No strategy is the holy grail—even the best strategy makes a loss.
4. Set your profit targets and maximum acceptable loss. Remember the saying, 'Greed kills good investors', and exit your position when the stock reaches your price target.

How to increase the possibility of success

Start small. If you are new to options trading, it is wise to start small, as this will give you time to understand the market and gain experience. Also, always remember that trading is risky—do not invest more than you are ready to lose.

Use technical analysis. For decades, all investors have used technical indicators to identify potential areas of entry and exit. Besides, in technical analysis, you can add chart patterns, such as harmonics and candlestick patterns, to improve your strategy.

Stay informed. Good investors are constantly updated on the fundamentals that impact the market. Thus, select blogs or channels that will keep you updated with news like earnings reports, consumer price indexes, and other essential factors that significantly impact your chosen assets.

Diversify your portfolio. Do not put all your capital in one asset. Creating a portfolio will help you succeed since the unprofitable positions will be offset by others.

Final thoughts

• Long-call option trading is a type of investment that allows buyers to earn profit due to its leveraged nature.
• The main components of a long call include the premium (maximum loss), strike price, and expiry date. Profitability depends on the underlying asset's price exceeding the strike price plus the premium by expiration.
• Advantages include leverage, limited risk, flexibility in choosing strike prices and expiration dates, and high-profit potential in bullish markets.
• Disadvantages are the possibility of losing the entire premium if the option expires worthless and the non-linear price movement due to delta, meaning the option's price doesn't increase one-for-one with the underlying asset.
• As a new investor, you should conduct market research and take small steps during the initial phases. Remember that option trading can result in massive losses; thus, invest only the amount you are willing to lose.