Introduction
Options can provide investors with an extremely versatile tool that can be used to bet on market direction or changes in volatility levels. Long options positions can be initiated with defined risk, and may present excellent profit potential. Although options trades can become quite complicated, sometimes simpler is better. One of the simplest positions available to both seasoned and novice options traders is the long call.
Description of the Strategy
A bullish call option position is exactly that: a long option. Call options are derivatives that give the buyer the right, but not the obligation, to buy an asset at a specified price at a specified date in the future.
All options have an expiration date. On this date, the option will either be “in the money,” in which case it may be exercised or assigned, or “out of the money,” in which case it simply expires worthless.
A call option is a simple, defined risk manner in which to express a bullish opinion of a market.
Here is an example: Suppose that you have been watching stock AAA, which is currently trading at $85 per share. The stock has been trending higher, but recently saw a five percent pullback. You feel that the recent decline represents a great opportunity to take a long position.
Instead of buying 100 shares of the stock outright, you decide to buy a $87 call option with 60 days until expiration. You pay a premium of $.50 for the option.
Now, suppose that the stock does in fact climb, and at expiration is now trading at $90 per share. In this case, the break-even of the option is calculated as the strike price ($87) plus the premium paid ($.50) for a break-even level of $87.50. Because the stock is now at $90, the profit is calculated as the break-even level of $87.50 plus the current price of $90 for a total profit of $2.50.
Every point that the stock price rises above the break-even level will result in a point-for-point gain on the call option.
Now suppose that your stock forecast was completely wrong, and the stock not only doesn’t climb but declines. If the stock is below the strike price of $87 at expiration, the option would simply expire worthless and the premium aid would be lost.
When to put it on
A bullish call may be utilized if you believe the stock or asset price will climb in value prior to the expiration date. A bullish call option may also be suitable for a situation in which implied volatility levels have seen a significant decline, or are trading below key averages.
Although a call option can be purchased at any time, there are a few scenarios in which it may make the most sense. Purchasing a call after a market decline, as in the example above, may be a way to enter a long position in a market that is in a longer-term uptrend.
Another situation where a call may be appropriate is when a market has declined into a key support level. Markets that decline to such levels may see bargain hunters step in to buy, and thus can potentially be a bullish reversal point.
Pros of Strategy
A bullish call position can have several key advantages. Possibly the most significant advantage is the defined risk characteristics of such a position. When you purchase a call option, your risk on the trade is limited to the premium paid for the option plus any commissions and fees, regardless of what the market does.
A call option can also potentially provide a larger return on investment compared to an outright position in the underlying. Buying stock may require a large amount of capital, whereas an option may tie up less investment capital.
A call can also potentially profit from a rise in volatility as well as higher prices.
Cons of Strategy
Although options have a number of potential advantages, they do also have some notable disadvantages. Because options have an expiration date, they will lose value over time with all other variables remaining constant. An option can also lose value, even if the market moves favorably, if there is a significant decrease in implied volatility levels.
In a nutshell, a long option holder must not only be correct about the market direction, but must also be correct about timing and volatility conditions.
Risk Management
There are numerous schools of thought when it comes to risk management of an option. A very simple, yet effective, method of managing risk is to simply cut the option once it loses half of its value. In one example, if you paid $1.00 for an option and its value declines to $.50, take the lump and move on to the next trade.
Another method may be to cut the option once it reaches a certain amount of time until it expires. For example, if you buy an option with 90 days until expiration, then cut the option when it reaches 30 days until expiration.
Possible Adjustments
A long option can also be adjusted during a trade. For example, if a long call is showing a profit but is approaching expiration, you could sell the call back to the market and “roll” out by purchasing another call option of the same or different strike price for a later expiration.
You can even sell a short call against a bullish call once the position has become profitable. Doing so may lock in a profit, but will also cap the profit potential of the trade.
The bullish call option is one of the simplest, yet most powerful options positions you can put on. This trade carries defined risk, with unlimited profit potential. Long call options can be a losing proposition if not managed properly, yet can also potentially yield rapid and dramatic results if a market has s sudden and explosive move higher.
The bullish call is one of the easiest options trades to learn, and given its simplicity and risk characteristics should be a tool in any trader’s toolbox. That being said, any strategy will yield lousy results without proper and disciplined risk management techniques.