Lesson 2: Understanding Purchased (Long) Calls

Understanding Purchased (Long) Calls

Long calls are purchased to open

Let’s break down a long call. Long means purchased and call means contains the right to buy. To create a long call, the trader buys to open the call, paying a premium in the form of a debit. Purchased contracts are intended to contain as much value as possible.

Maximum loss is limited to the premium paid

Only option buyers can execute upon the terms of the contract. This means that long calls are exercisable. In this example, the long call holder owns the right to buy ABC at $100 at any time through the expiration date. In simpler terms, it’s the buyer’s decision , they decide when they would like to own the shares, if at all. The long call holder pays a premium (options price) for the contract. As the long call holder decides when to exercise, the most that can be lost is the premium paid for the option. In this example the most that can be lost is the premium paid for the option. In this example the most that can be lost is $5 per share or $500 total as the contract represents 100 shares.

Lesson 2: Understanding Purchased (Long) Calls

Understanding Purchased (Long) Calls

Long calls have unlimited profit potential

When purchasing an option contract, the contract holder wants the option to go up in value as much as possible. The long call holder owns the right to buy 100 shares of ABC at the $100 per share strike price. Therefore, the long call holder desires ABC stock to rise well above the $100 strike price as this increases the contract’s value. As ABC can increase to an infinite amount, long calls contain unlimited profit potential.

However, the long call holder paid $5 per share or $500 total for the contract. On expiration, an option is generally worth only its executable value – this also called in-the-money (ITM) value or intrinsic value. Which means if ABC is at $105 per share on expiration, the long call holder would break-even and not realize a gain or a loss. This is because the long call holder can execute upon the terms of the contract and buy 100 shares of ABC at $100 per share and then immediately sell the shares on the market at $105 per share. This would create a gain of $5 per share, offset by the $5 per share purchase price of the call. The difference of transactions causes the call option holder to break-even.

Time is working against long options

Options that contain longer expiration dates are more expensive as there is more time for the option to rise in value. As the option nears expiration, the time value component of the options premium will deplete. When purchasing options, it may be beneficial to sell to close the long option prior to expiration to recoup or recapture any time value purchased. Essentially, there are other pricing factors that affect an options premium outside of the underlying security. This is why the option does not move in tandem with the underlying position.