100% Upside with Limited Downside Risk? Introducing the Long Call
One of my favorite advantages in the world of equity options is the ability to participate 100% in an equity’s bullish move for a fraction of the investment. We accomplish this through the use of the long call option. To be long a call means that you purchased the call option giving you temporary control of shares of the underlying equity. The long call option gives the buyer the right to purchase 100 shares of the underlying equity at a certain price point – called the strike price – during the limited lifetime of the option. The price paid for this control of the shares is a fraction of the investment made in the same actual 100 shares of the equity. Like most things in life, however, there are many considerations to be made when it comes to purchasing a call option.
The long call option has an expiration date. This is the date upon which your right to purchase those underlying shares comes to an end. You may choose at any point along the way to exercise your right and have those shares delivered to your account at the agreed upon price – the strike price – through the date of expiration. After this time, if you have no advantage in exercising your right, your option will expire worthless and you will lose the entire premium you paid for it. If you had elected to purchase shares instead, assuming that the company is still in business and the shares are still trading, you would be able to continue in your investment as long as you like.
One of the main benefits of utilizing options contracts is the leverage they provide. As mentioned earlier one long call contract controls 100 shares of the underlying equity. The investment in the long call will be a fraction of the investment for the shares. For example, let’s say you are expecting for Apple (AAPL) to resume its bullish uptrend and you wish to participate in the movement. At the time of this writing, AAPL is trading at roughly $671 per share. To purchase 100 shares, it requires an investment of just over $67,000, all of which is at risk. Instead of purchasing the stock, what if you utilized a long call instead? With a long call, you purchase the November 2012 670 strike call for a premium of $1,500. This premium is the most you can lose in the trade. You have purchased the right to buy AAPL shares for $670/share up through the third Friday of November (options expiration Friday). If your expectation is correct and AAPL continues to move bullishly, the call will provide a better absolute % return than the shares. Let’s assume that AAPL moves up to $700. If you owned the shares, you would be profitable by $29/share or $2,900 on your $67,000 investment – a return of 4.3% on your investment.
In contrast, your November 700 call option has a delta of .50. Delta represents the dollar amount of change in options premium your contract will experience with a $1 change in the underlying equity. In this example, every dollar of bullish movement by AAPL results in a gain of $50 on your long call. With the increase of $29/ share, this translates to growth in the options premium of $1450. With the initial investment of $1,500 for the call, this is just shy of a 100% return. Talk about leverage! You could sell that long call back to the market and take the profit without having to actually purchase the shares. You could also choose to exercise your right with the long call and purchase shares at the 670 strike. You could then turn around and sell the shares back to the market for $700. When you exercise an option, you give up the premium you paid for the contract. In this case, you would profit $29/share x 100 shares – $2,900 – but forfeit the $1,500 you paid for the call for total profit of $1,400. Keep in mind, however, that leverage works both ways. If instead of climbing $29, AAPL fell $29, you could potentially lose 100% of your investment if you don’t possess the knowledge of how to adjust the trade to the trend that AAPL is exhibiting. This is why it’s important to educate yourself about trading. At OptionsANIMAL, we specialize in trading education. Our educational process shows you how to adjust the structure of a trade when you do not get the trend you anticipated so that you can make a trade fit the trend you have – not the trend you want.
While this may “scratch the surface” on the complexities of option investing, it does show how, with the right knowledge, you can learn to profit handsomely in the world of long calls. Bring on the bulls!