Playbook: Basis: the Long Call

Long Call

The long call is the most basic of all options strategies, the most well-known and best understood.

The long call is the opposite of the long put.

A call is an option to buy. The buyer of the call option has a right to take delivery (call). The seller has the obligation to take the other side (sell the call).

The position benefits from IV/IVR expansion and/or underlying price increases above the strike.

Considerations

General

The reason for selecting this option strategy is that you expect the underlying to rise and be ‘In The Money’ (ITM: stock > call strike price). You make a better return than if you had bought the underlying itself.

These are the considerations for entering a short call:

• The expectation that underlying (stock, ETF, index, future) will rise: the outlook is clearly bullish.
• The underlying has just experienced a pullback/decline.
• Implied Volatility (IV)/IVR (IV Rank) is low (<30), looking for options to increase in value over time.
• It’s difficult to sell (‘short’) premium as a leveraged alternative to selling/shorting the underlying.
• To reduce the cost base, if interested in purchasing shares at a selected strike and expiration date (indexes are cash-settled); non-cash settled underlyings deliver ownership of the shares at exercise.
• Risk is limited (‘defined’) to the premium paid (‘debit’).
• The maximum reward is unlimited.
• When you buy and therefore own an option, you are exposed to time (value) decay (‘hurts’), so typically, expiration dates should be reasonably far away (so >90 up to 180 DTE or even higher) to give you more time and a chance of the option increasing in value; so the period to trade is at least three months, preferably longer.

You can also consider LEAPS (trick if you think they’re expensive: divide the price by the number of months up to expiry and compare to shorter-term option prices).

Description

Set-Up

1. ‘ Buy to open’ (BTO) the call option ( in US 1 contract = 100 shares) at the call strike at which the underlying will be delivered if the right to purchase is exercised
   • .50Δ slightly ATM/ITM in less volatile underlyings
   • .30Δ OTM in more volatile underlyings

Another method is buying deep ITM call options. Calls are ITM if price underlying > call strike.

Related Options Strategies

The long call is one of the four basic options strategies on which all other strategies are built, especially options strategies with long call legs: vertical, calendar, and diagonal spreads, condors butterflies, reverse straddles and strangles, etc.

The Greeks

GREEK

+/-

Notes

Profile

Delta (direction speed)

+

Positive (speed) increases fastest around the strike price (delta 0.5 or 50) until it reaches 1 (or 100). Delta = 0 when the option is deep OTM

Gamma (acceleration)

+

Always positive and peaks when Delta is at its fastest (around strike price)

Theta (time decay)

–

Negative since time decay works against (‘hurts’) the long call option.

Vega (volatility)

+

Volatility is helpful to the position since higher volatility = higher option value

Rho (interest)

+

Positive, higher interest rates increase the value of calls and help the position

Entry Rules

Profitable long calls require correctly selecting bullish underlyings AND good timing.

Criteria

• Acknowledge whether market sentiment allows trade.
• Check whether trade fits in portfolio allocation rules.
• Ensure stock meets all of your selection criteria (volume, open interest, ask-bid range, etc.).
• IV/IVR below 30%.
• Ensure the trend is upward/bullish.
• Ensure at least three of the technical momentum indicators are positive.
• Identify the clear areas of support and resistance.
• Make sure there are no major events (dividends, earnings) within 30 days of the expiry date.
• Profitability of Profit at selected strike: around 50%.
• Backtest (since 2006 and last 200 trades): at least $1.00 (average and mean) profit/day.

Technical Indicators Used

1. Trend = bullish
2. Support & Resistance = the underlying has just experienced a pullback/decline to clear support level
3. RSI = oversold
4. Bollinger Bands in combination with Keltner Squeeze: at the bottom and outside Keltner bands
5. ADX/DMI: increasing up and above 20
6. ATR low

P/L and Risk Profile

Net Position

Net debit, because you pay to buy the put option.

Theoretical Profit

As the stock price rises, the long call moves into profit more and more quickly, particularly when the stock price is higher than the strike price.

The reward is uncapped/unlimited when underlying price > call strike.

As the stock price rises, the long call moves into profit more and more quickly, especially when the stock price is greater than the strike price.

Theoretical Risk/Risk Profile

The maximum risk is the price you initially pay for the call (‘net debit/premium’) if the underlying price decreases below the long call (even considerably).

If the underlying price decrease to/below the long call: expires worthless.

Breakeven

Underlying call strike + net call premium/debit.

Managing and Closing Position

Halfway to/Near Expiration

To better manage the position/mitigate losses: convert a profitable long call position into a long call debit spread: sell an OTM call against the long call for a credit => (equal to or higher than) the initial cost of the long call.

Rules for Managing/Adjusting Position

• If the underlying increases to the breakeven, the initial net premium/debit is covered (net even).
• If the underlying increases above breakeven, the buyer will profit.
• Set alerts on breakeven/predetermined target.

Rules for Closing Position/Exiting the Trade

• Profitable positions are closed by selling the option (STC) to close for a higher price than the net premium/debit paid to open the position.
• If not profitable and the underlying is trading below your stop loss, exit be selling the calls.
• Taking ownership of the shares at a cheaper strike price.
• Sell the call option before the final month before expirations (to avoid time decay), so not later than 35 DTE.
• Manage multiple long calls by closing a portion of the position for profit, keeping some in place.

Mitigating a loss

• Work with a (mental) stop loss based on an underlying asset of either 50% or 100% of the premium paid; if the underlying falls below the stop loss, exit by selling the calls.

Additional Notes

Advantages

• Leverage (1 contract = 100 shares).
• Cheaper than buying the stock.
• Greater leverage than owning the stock (1 option represents 100 shares).

Disadvantages

• Paying a net debit/premium.
• Possibility of 100% loss of the premium paid.
• No equity/margin value.

Exercise/Assignment

Long calls can only be ‘exercised’. For this, you need to contact your broker.