TOOLS OF THE TRADE
THE LONG CALL
OPTIONS BASICS
Options are sometimes referred to as derivatives in that they are related to and are derived from the underlying security. There are two types of options, Calls and Puts. Options are purchased in “contracts”. A contract is usually equal to 100 shares of stock. So, if a trader purchases 10 contracts on an underlying stock, that trader now controls 1000 shares of that stock for a fraction of what it would normally cost to buy the stock outright.
Options are made available for purchase or sale in what is termed “option cycles”. There are three cycles 1) January, April, July, and October. 2) February, May, August, and November. 3) March, June, September, and December. There are tables known as “Options Chains” that represent the prices for both Calls and Puts at various price points called “Strike Prices” for each month in the cycle. There are also long dated options available on many but not all stocks. These options are called LEAPS which stands for “Long Term Equity Anticipation Securities”. These options are available in January and would allow a trader to purchase or sell an option on an underlying security up to 2 ½ to 3 years out.
Options can be used to speculate on price appreciation or depreciation of the underlying security or more conservatively, to hedge stock positions to protect against loss.
THE LONG CALL
Today, we will discuss the “Long Call” at the money (the strike price closest to where the stock is currently trading). When the trader purchases a long option, it gives that trader rights. A long call gives the trader the right but not the obligation to purchase the underlying security at a predefined price point (the strike) for a stipulated period of time in exchange for the premium paid for that option. We can also sell options, but that will be a future discussion.
Long Call Risk Graph
*Risk graph courtesy of Options Industry Council
As you can see in the risk graph, there is a defined risk which is the cost or net debit of the option. The trader can under no circumstance lose more than the cost of the option. Yet, the upside potential is theoretically unlimited. Options are “decaying assets”. As time move closer to the option expiration, the option loses value. So, in order for the trader to be profitable in a long call position, the stock must move up before the option expires.
There are other factors to consider when purchasing long options that effect profitability. Options are not linear like stocks. If you are long stocks, you win if the stock goes up and you lose when the stock goes down. Options on the other hand are multi dimensional in their price structure and are effected by more factors than just the price of the underlying security. We will discuss those factors in greater detail in future posts. Study the graph to gain understanding of your risk and reward in the long Call position. Next week, we will discuss and graph the “Long Put”. Robin
RSS feed
