DESCRIPTION: A bullish instrument that allows an investor to benefit from a rise in the price of the underlying instrument without limit. This is the simplest of bullish trade structures and alternative to buying the underlying stock. Calls allow for a great deal of leverage as one can control stock for just a fraction of its market value with limited risk. In doing so, the risk of loss is limited to the premium paid.
MOTIVATION: The investor who buys a call seeks to capture a profit from a rise in the price of the underlying asset. The advantage of this structure vis–à–vis short selling stock outright is that one can take a position with a much smaller capital outlay upfront (margin) while taking less downside risk. Consider the above example of a long put call with the following features.
OUTLOOK: The investor who buys a call is looking for a sharply higher price of the underlying asset to occur within a certain amount of time. Calls are appropriate when the investor has conviction behind an investment thesis, or they are looking for a particular catalyst to move the share price within a certain window of time.
PROFIT/LOSS: Maximum (Asset Price – Strike, 0) – Premium Paid
The amount one earns at expiration is equal to the price of the underlying asset less the strike price or zero, less the initial premium paid, to buy the call.
MAXIMUM GAIN: (Asset Price – Strike Price) – Premium Paid
Just like with stock, there is no upside limit to the gains one can make by owning a call option.
MAXIMUM LOSS: Net Premium Paid
The maximum one can lose is the premium they pay up front to establish the position. This will happen if the stock sits at a price below the strike at expiration.
BREAKEVEN: Asset Price = Strike + Premium Paid
The investors will breakeven if the asset price at expiration is above the strike price of the option by an amount equal to the premium paid when the trade was initiated.
VOLATILITY: An increase in implied volatility would increase the profitability of a long call position. After price, implied volatility is the second most important factor in determining an options price.
TIME DECAY: The market value of a call will decline as time passes. Time decay increases as implied volatility increases and the time to expiration declines.
ASSIGNMENT RISK: None. The owner of an option decides if they want to exercise or not.
EXPIRATION RISK: Not very high. The risk around expiration concerns whether or not the owner of a call should exercise when the stock is trading within a penny or two of the strike price.
STRATEGY PAIR: The profit/loss payoff profile for a long call is the same as that for a long stock and long put synthetic. Put-call parity suggests that stock plus a put is equal to cash plus a call. So a call is the same as holding the stock with a married put.