We know there are two common ways to trade stock.
If you expect the price of a stock to rise, you can open a long position, buying its shares first and selling them later. Or you can do it the other way around to short sell the stock if you believe its price will fall.
In the options world, there are many more approaches available.
Apart from simply going long or short, traders could achieve their investment goals with various strategies. That's why options trading is so appealing to many advanced investors.
But for beginners, you'd better first get the hang of the two most basic strategies, i.e., long call and long put, before jumping into more sophisticated trades.
In this chapter, let's start with buying a call.
Suppose you're bullish on a stock and expect its price to rise shortly. So you want to buy 100 shares of the underlying (the stock) with a total principal amount of around $10,000.
Basically, you could buy the shares of the stock directly, or you could purchase its call option.
If you choose to buy 100 shares directly, you'll need to pay $10,000 in cash, or you could borrow some money from a broker and pay some interest. On the other hand, you may only need several hundred dollars to buy the stock's call option as it is leveraged.
But remember, options' profits aren't linear: when the underlying moves upward, the option's price generally rises more significantly; but when the underlying goes down, the option's downward movement is likely to be bigger, too.
Therefore, options can magnify both potential gains and losses.
Now comes the key takeaways about the long call strategy.
Here's an option chain. Let's take the call at a strike price of $55 with a $1.35 premium as an example. As a U.S. stock option generally represents 100 shares, you'll need to pay $135 ($1.35×100) to get this call.
Let's then look at its Profit & Loss (P/L) diagram.
The worst-case scenario for a long call is that the stock price doesn't exceed the strike price, making the option worthless. In this case, your maximum loss will be the premium you paid.
To make things easier, let's ignore commissions and other fees for illustration purposes in this course.
But the reality may not be that bad. If the stock price rises above the strike price, the call option will have its intrinsic value, the difference between the stock price and the strike price. But if the stock price doesn't go up that much, you'll still lose money because you've paid the premium to buy the call. In other words, the break-even point for a long call is the strike price plus the premium you paid.
If the stock price surpasses the break-even point, you'll make a profit. Theoretically, the stock price could skyrocket, making the maximum gain unlimited.
To summarize, we can break down the risk profile of a long call into three scenarios:
If the stock price is lower or equal to the strike price, the contract will expire worthless. Therefore, the maximum loss is the premium you paid.
If the stock price is greater than the strike price but lower than the break-even point, you'll still suffer some losses as the option's intrinsic value is not enough to cover the premium you paid.
But if the stock price is greater than the break-even point, which means that the option's intrinsic value exceeds the premium you paid, you'll make a profit.
Remember, options contracts do not have to be held to expiration. Because if you do so, you may lose all of the time value so critical to an option. So once the call's price has reached your expectation, you may need to consider whether to sell it to close your position. After all, the "buy low and sell high" mantra works in most cases. On the other hand, if the market moves against you, you may also need to stop loss at the right timing.
Time is a friend for option holders. The closer you get to expiration, the further your friend is away from you.
Okay, so much for today’s long call strategy. Clear about it now?
In the next chapter, we’ll talk about the long put strategy. See you next time.