For novice traders, the long call is usually the first type of options trade they encounter. Buying long call options comes closest to what most of us are familiar with: trading in shares, currencies or commodities.
A long call option is the right, but not the obligation, to buy a particular asset at a certain price at a certain future date. The agreed price is called the ‘strike’ price and the date is referred to as the expiration date of the option.
Benefits of buying a call option
The biggest benefit of a purchasing a call option is that it gives one access to the potential profits on a much larger investment in shares, commodities or forex. This is because options are leveraged, a concept which we explain in more detail elsewhere.
Another major benefit of call options is that they carry limited loss. When a trader buys a call option, he or she can never lose more than the purchase price of the option.
Risk/Reward of Call Options
Fig. 8.15 below is a chart showing the risk/reward payoff for call options.
This chart makes it immediately apparent that call options are a great vehicle if one wishes to profit from a sharp increase in the profit of the underlying asset without spending the same amount of money an outright purchase of the asset would require.
Profit/loss scenario when trading call options
From Fig. 8.15 it is also clear that the maximum loss when buying a call option is limited to the amount the trader paid for the option.
The maximum profit will be directly related to the upwards price movement of the underlying asset. There is, however, the rather significant issue of Delta that plays a role here. To recap: an option’s Delta is how much it moves for every $1 movement in the price of the underlying asset.
Since most beginners would buy At the Money (ATM) options, the Delta of their options would be 0.5. This means that for every $1 movement in the price of the share, currency or commodity the price of the option would increase by $0.50. If the option is ITM at expiry, however, its Delta will become 1 and the trader will get the full benefit of the price increase.
Let us assume the shares of company ABC sell for $100 at present and that one can buy a call option for $2. What are the profit/loss possibilities?
Loss: The trader can never lose more than $2 per option. Since one options contract is for 100 shares, that means the total potential loss is limited to $200.
Profit: Remember that the trader paid $2 for the option. If the price of the underlying asset therefore increases with $2, breakeven point will be reached. For any movement above this price, the trader will benefit with $0.50 for every $1 movement in the asset price. This is vital to understand for a trader who considers selling the option before expiry.
If the option is ITM at expiry, Delta will be become 1, and the trader will benefit from the full movement in the price movement of the underlying asset, less the cost of the option. A $10 increase in the underlying price would therefore mean a $10-$2 = $8 profit for the options buyer, i.e 100 x $8 = $800 per options contract.
Alternative to ATM calls
At the money (ATM) call options are much more expensive than OTM call options. A trader who is convinced that the price of a particular trading asset is going to rise strongly might consider buying cheaper OTM call options. Although these require a bigger movement in the price of the underlying asset to profit, the percentage profit could also be much higher – and the maximum loss is lower than with ATM call options.