Bullish Option Strategies » Long Call

Let's imagine you have a strong feeling a particular stock is about to move higher. You can either purchase the stock, or purchase 'the right to purchase the stock', otherwise known as a call option.

Buying a call is similar to the concept of leasing. Like a lease, a call gives you the benefits of owning a stock, yet requires less capital than actually purchasing the stock. Just as a lease has a fixed term, a call has a limited term and an expiration date.

Example

Let's look at an example option. Microsoft (MSFT) is trading at $30, it would take $30,000 to buy 1000 shares of the stock. Instead of purchasing the stock you could purchase a MSFT "call option" with a strike price of 30 and an expiration 1 month in the future. For instance, in May you could Buy 10 MSFT JUN 30 Calls for $1.00. This transaction will enable you to participate in the upside movement of the stock while minimizing the downside risk of purchasing stock.

Since each contract controls 100 shares, you bought the right to purchase 1000 shares of Microsoft Stock for $30 per share. The price, $1.00, is quoted on a per share basis. As such, the cost of this contract is $100 ($1.00 x 100 shares x 10 contracts).

Option purchase example
MSFT trading @ $30.00
Buy 10 MSFT JUN 30 Call $1,000.00
Cost of Trade $1,000.00

If the stock stays at or below $30 before the options expire, $1,000 is the most you could lose. On the other hand, if the stock rises to $40 at expiration, the options will be trading around $10 (current price: $40 - strike price: $30). Thus, your $1,000 investment will be worth $10,000 ($10 x 100 shares x 10 contracts).

If the stock price increases, the option gives you two choices: sell or exercise the call. Many investors choose to sell because it avoids the substantial cash outlay involved in exercising your call option. In the example above, to exercise you would pay $30,000 ($30 x 1000 shares) to buy the stock when you exercise the options. At a market price of $40, your shares would actually be worth $40,000. Not including commissions, you would have made a $9,000 profit on your $1,000 investment ($10,000 - $1,000).

Long call example graphicLong call example graphic

Compare this to selling the options: you realize the same profit without spending the money to buy the shares. With the stock at $40, the Jun 30 calls would be worth $10 per contract. Thus, each option contract would have a value of $1,000 ($10 x 100 shares * 10 contracts). Not a bad return for a $1,000 investment!

The scenario described above is a great example of the leverage that options provide. Just look at the returns on a percentage basis.

Option returns on a percentage basis
  Purchase Price Sale Price Profit (L) % Gain (L)
Stock Price $30.00 $40.00 $10.00 33.3%
1,000 Shares $30,000.00 $40,000.00 $10,000 33.3%
10 JUN 30 Calls $1,000.00 $10,000.00 $9,000.00 900%

As the chart above demonstrates, if you bought 1000 shares of stock at $30, you would be putting $30,000 at risk. If you sold the stock when it rises to $40, you make $10,000 on your $30,000 investment, a 33.3% return. In contrast, investing $1,000 in call options only puts $1,000 at risk. In this case, the return is 900%.

Now, let's see what happens when the stock drops.

Option returns on a percentage basis
  Purchase Price Sale Price Profit (L) % Gain (L)
Stock Price $30.00 $20.00 ($10.000) (33.3%)
1,000 Shares $30,000.00 $20,000.00 ($10,000.00) (33.3%)
10 JUN 30 Calls $1,000.00 $0.00 ($1,000.00) (100%)

While this scenario looks scary on a percentage basis, when you look at the raw numbers, it's clearly relative. If the stock drops, your calls may expire worthless, but your loss is limited to your initial investment, in this case $1,000. In contrast, the stockholder sustains a far larger dollar loss of $10,000. When you compare the limited downside and the unlimited upside potential of call options, it easy to see why they are such an attractive investment for bullish investors.