Long Call Strategy Explained

Long Call Strategy Explained

The long call strategy is a basic strategy where the buyer (the option holder) has the right (but is not forced to) to buy or sell a security at a predetermined price in the future is an option. For such a right, sellers charge option buyers a fee known as a premium. If market prices are unfavourable to option holders, they will let the option lapse and not exercise the right, ensuring that potential losses do not exceed the premium. However, if the market moves in a direction that increases the value of this right, they will exercise it.

Contracts for options are generally "call" or "put." A call option contract allows the buyer to purchase the underlying asset at a predetermined price, later known as the exercise price or strike price. A put option will give a buyer the right to sell the underlying security at a predetermined price.

Let's look at some basic risk-management strategies that a new investor can employ with calls or puts. If the gamble fails, the first two involve using options to place a directional bet with a limited downside. Others include hedging strategies that are applicable on top of existing positions.

What Is a Long Call Option?

A long call is a call option that bets that the underlying stock will rise in value before the option expires. If you purchase a long call option, you are looking for rising in stock or other security prices to enable you to earn a profit from your contract by exercising your right to purchase that stock to sell them to make a profit immediately.

To enable the "long a call option," you have to buy calls on a specific stock, and the call seller has a short position in the options. A long call is a bullish options trading strategy that is one of the most common. The rise in call value if the underlying stock price rises, which is why you would buy a call option if you have reason to believe the stock price will rise.to

Long Call — Example

Suppose that a stock trader buys one call option for ABC with a  price of ₹200 and a month expiration date. As the option holder, the trader has the right to purchase 100 shares of ABC at ₹200 until the option expires. If the price of ABC rises above ₹200 to ₹210 in that month, the buyer can sell them right away, resulting in a ₹10 profit per share for the buyer.

Calculation of Breakeven Price on Long Options

A trader buys one call option for ABC with a price of ₹200 expiring in a month. As the trader is the holder of the option, he has the right to buy 100 shares of ABC at ₹200 until the expiration date. If the price of ABC rises above ₹200 in that month to₹210, the buyer can immediately sell them at ₹210. The buyer will earn a profit of ₹10 per share.

Formula

Breakeven point = premium paid strike price of long call  

What Is At The Money (ATM)?

At the money (ATM) refers to a situation in which the strike price of an option is the same s the current strike price of the underlying stock. An ATM option has a delta value of ±0.50, which is positive if it is a call and negative if it is a put. ATM options have no intrinsic value, but they have extrinsic or time value before they expire.

Both Call and Put Options in ATM

ATM can be both calls and put options at the same time. 

For example, if a stock's call and put long call options both have a market price of ₹100 and the underlying security is currently trading at ₹100, the call and put are both at the money.

ATM options have no intrinsic value. However, they will have extrinsic or time value before expiration and are comparable to in the money (ITM) or out of the money (OTM) options.

At-the-Money Options—Working

ATM is one of three terms used to describe the relationship between an option's strike price and the underlying security price, also known as the option's monetary value. ATM options will not profit if exercised, but they still have value—there is still time before they expire to end up in ITM. ITM denotes that the option has intrinsic value, whereas OTM indicates it does not.

At-the-Money Options' Value

The total value is the difference between the strike and underlying asset prices, assuming the option is to exercise it immediately. 

Example

The call option has a favourable intrinsic value of 20 because it grants the right to buy an asset worth 120 for ₹100. The put option will not have an inherent value because you cannot profit from it or exercise it.

Formula

Time Value = Total Value – Intrinsic Value

Suppose an option that is 'in the money' has no intrinsic value. Because the option's strike price and the current market price are the same, the option holder cannot profit from exercising the option. At the same time, an at-the-money option has only a time value, which means the holder can only make a profit if they exercise the option at the right time.

The Volatility Smile in At The Money Options

A u-shaped curve is known as the "volatility smile." If an option is 'at' or 'near the money,' the implied volatility is lowest, and it rises as the option moves further out of or into the money. When options with different strike prices but the same characteristics are comparable, the volatility smile indicates that out-of-the-money options have higher option prices.

What is Near The Money?

The term Near the Money (NTM) is sometimes used to describe a choice that is only 50 paise away from being an ATM. 

Example

Let us assume an investor buys a call option with a strike price of ₹50.50 while the underlying stock price is ₹49.50. 

When the call option is just a wee bit short from the At the Money or ATM, it is near the money option.

Particular Considerations

ATM options are the most vulnerable to various risk factors, referred to as an option's "Greeks." ATM options generally have a delta of ±0.50 but the highest gamma. As the underlying moves, the delta will move away from ±0.50 quickly, especially as the expiration date approaches. Traders frequently use ATM options to build spreads and combinations. Straddles, for example, will typically entail purchasing both an ATM call and a put.

Pricing Options

The price of an option is a combination of intrinsic and extrinsic value. When trading options, extrinsic value is sometimes referred to as time value, but time is not the only factor to consider. Implied volatility is also essential in option pricing. 

ATM options, like OTM options, have only extrinsic value because they have no intrinsic value. For instance, suppose an investor pays 50 paise for an ATM call option with a strike price of ₹25. The extrinsic value is equal to 50 paise and is heavily dependent on time and changes in implied volatility.

Presuming that volatility and price remain constant, the relatively close the option expires, the less extrinsic value it has. If the underlying security price rises above the strike price to ₹27, the option gains ₹2 in intrinsic value plus whatever extrinsic value remains.

Wrapping it up

Call options are one of the most inspiring and profitable segments of modern finance. You can use them to generate profits that are frequently greater than your initial investment and create sophisticated and complex positions. Call option buyers can also capture all of the upside potential of a given stock for a small percentage of the share price.