When to Buy a Call Option: Strategy and More
Y ou’ll find various long options strategies you can use when you’re trading and want to buy calls. Many options strategies can maximize return and limit risk, so before you dive into trading options, it’s important to gain an understanding of the different strategies available to you.
- Buying a call option gives you the right (but not obligation) to purchase shares of an underlying asset at a specific price before a specific date.
- Buying a call is a simple, popular strategy that many investors use when they think the underlying price of a stock will rise.
- You can also use various other call option strategies such as spreads and butterfly strategies to maximize profits or mitigate risks.
What Does It Mean to Buy a Call Option?
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Buying a call gives you the right, but not the obligation, to buy shares of an underlying stock at a specified price before a specific date. The specified price is known as the strike price, while the end of the specified time frame is known as the expiration date. Typically, you buy 100 shares of the underlying stock with this kind of option.
Any option is a limited time contract. Options have expiration dates by which the contract must either be sold, exercised to buy the stock, or allowed to expire.
Buying a call is a bullish strategy. This is because the call’s value tends to increase as the underlying stock price rises. The gain increasingly reflects the rise in value of that underlying stock as the market price goes above the strike price of the option.
The long call options strategy offers unlimited profit potential while the underlying stock keeps rising. The strategy also limits the financial risk you take, regardless of how low the price of the underlying stock goes. A stock has various different options trading against it at any given time, with several expiration dates and a number of strike prices both above and below its current stock price. To be long on a call option means you purchased calls on a particular stock. The seller of those calls has a short position.
The break-even point when you buy a call is the underlying stock price equal to the strike price, plus the premium you pay for the contract. If volatility increases, this has a positive financial effect on your long call strategy (as with other long options). Decreasing volatility and time decay both have negative effects.
When Should You Use a Call Option Strategy?
Buying a call is one of the most popular strategies option investors use. It’s also one of the simplest strategies out there. When you buy a call, you have the ability to profit from an upward move in an underlying stock’s price. At the same time, you risk less capital than you would if you were to buy the equivalent number of underlying shares outright.
You can buy a call when:
- You are very bullish on a given stock and want to profit from its rise in price.
- You want to take advantage of the leverage options offer, along with the limited cash risk.
- You think the value of a particular stock will rise, but you don’t want to commit all of the capital you would need to buy those shares.
A long call options strategy profits from higher stock prices. Your primary goal when using long options strategies, therefore, will be to pick stocks you think are going to rise in price soon.
You gain leverage from a call option compared to buying underlying shares outright since the lower-priced calls appreciate faster in value in terms of percentage for every point the price of the underlying stock rises. Keep in mind, however, that call options come with a limited lifespan. If the underlying price of the stock doesn’t go above the strike price before the expiration date on the option, the call option ends up expiring worthless.
Example of Using a Long Call Options Strategy
One of the most basic long option strategies is buying call options. Let’s say there’s a stock currently at $50 a share, but you think the price is going to go up to $60 or maybe even higher. You can buy call options with a $50 strike price and a $3 cost.
Remember that each option contract is typically 100 shares of stock. If an option is quoted at $3, it will cost you $300. Likewise, a share price gain of $1 is worth $100.
If that stock goes above $53, the long call option trade is already profitable for you. The option value increases with the stock price. You can sell the options you have when you want to lock in your profit.
You can utilize both bull call spread strategies or bear call spread strategies:
Bull Call Spreads
You can still make a profit from a smaller gain in price of an underlying stock if you use a long call spread. Using a call spread means you buy call options at one strike price while you sell calls at a higher strike price. Both call options will have the same expiration date.
The benefit of this call option strategy is that you reduce the overall cost of a trade by selling call options at a higher strike price than the call options you buy.
By using a spread, you limit the maximum profit to the difference between your strike prices, minus the cost of the spread. Let’s go with that $50 stock example again. You buy a $50 strike price call for $3 while selling a $55 strike call for $1. That makes your net cost $200, and you get to a profit position as soon as the stock price goes past $52 a share. However, your maximum profit is $300 if the stock goes to $55 or higher.
Bear Call Spreads
This strategy involves buying call options at a high strike price, then selling the same number of call options (again at the same expiration date) at a lower strike price. The calls you sell at the lower strike price always generate more income than the calls you buy at the higher strike price. You get the profit if a share price of underlying stock trades below the strike price of the calls you sell. If the stock ends up trading higher, the calls you buy mitigate that upside risk.
Other Call Option Strategies
You’ll find a variety of strategies for calls. Some other examples of popular strategies include:
You can go with a covered call when you want to maximize your potential profits on a stock you already have in your portfolio. Covered calls involve selling call options on stock you own already with the goal of earning income from the call option premium while you simultaneously benefit from the stock price rising. Covered calls are a strategy for creating a short-term hedge when you’re still bullish on a stock.
Long Call Butterflies
A long call butterfly may be a good option when you have a specific price target for a stock along with a specific date you want to make a trade. This strategy allows you to make a big bet on a given stock for a relatively low cost.
You can initiate a long call butterfly trade by selling two call options that have a strike price equaling your target price for that stock. Then, you’ll need to buy a call option at a higher strike price.
When you employ this strategy, you want the stock to hit the target price and have all the call options you sell expire worthless at the same time that the one call option you buy generates profits. You get the maximum profits from a long call butterfly if your stock trades exactly to the strike price of the pair of call options you initially sell.
What Is the Potential for Losses With Long Call Option Strategies?
When you use long call strategies, the most money you can use is the cost of establishing a trade. If the price of the stock is below your long call strike price when the options expire, you have a 100% loss. However, if the stock is above your strike price, your long options have an intrinsic value. You can capture that value by selling your options.
Back to the $50 stock price example. If you’re approaching the expiration date of the contract and the stock is at just $51, you can sell the $50 strike call option for at least $1. You’ve just earned $100 in this example.
Y ou can use call option strategies to maximize return and minimize risk when you’re trading options. Whether you buy a call option or go with a more complicated spread or butterfly strategy, these are important strategies to have as an options trader.