Long Call options
 

A call option gives you as the buyer the right to buy an underlying instrument at an agreed price within an agreed time period. The price for buying the underlying instrument upon redemption of the option is called a strike price. The last date to exercise an option is called the expiration date. The buyer of the options has the right to exercise the option contract with an underlying of 100 shares of the instrument.

Example of trading call options

After Phil has done due diligence, he determines that the share TMV is a good buy above the current price of 100$. He also knows that the company expects news in the future, and predicts that the news will be positive and that the share price will rise. After some further investigation, he finds that a call option is his best alternative, as he can capture the upside if the news is positive, but can also limit the downside to the premium in case of bad news. He, therefore, decides to buy an options contract within the time perspective he sees as realistic that the news will come. The trade will look like this at the broker:

Buy / Sell = Here he selects Buy to open to buy an option contract of the underlying instrument.

Quantity = Here he chooses how many options contracts he wants to trade with the underlying of100 shares per. option contract.

Expiry = Here Phil chooses the date he envisages that the news will come for the company. Expiry is thus when the option contract expires and the rights will expire.

Strike = The price Phil wants to be able to buy the underlying stock at.

Call / Put = Here he chooses Call.

Price = Price for each option contract, ie what he thinks is acceptable to pay per. an option contract, more about this below.

Supplemental description of the trade

Phil has decided to buy 5 x call option contracts, this corresponds to a position equal to (5 options x 100 underlying shares) 500 shares of the underlying instrument.

The closer the underlying instrument is to the strike price, the premium for the options will increase. Phil thinks there can be a big upside for the stock if there is good news. He also wants to buy cheap option contracts. He thus sets the strike price a bit above today's price on the underlying instrument. This is also called out of the money (OTM). This means that it will not be profitable to redeem the option contract with the current pricing of the instrument/stock in relation to the strike price. Phil places an order with a strike price equal to 110$, ie 10$ above the current price of the instrument TMV.

 

This means that he has the right but not the obligation to buy the shares at 110$ regardless of whether the share price falls lower or is higher within expiry. It is therefore the issuer that takes on the risk and the promise to sell the instrument at the strike price to Phil. To take on this promise, he receives a premium that is paid when the trade and the contract are agreed upon. In this fictional case, the price per option contract/premium has been set at 7$. This is the price per. an option contract, which goes to the issuer of the option.

The total price Phil has to pay for the trade is thus (5 option contracts * 100 underlying)  x 7$ (Premium) = 3,500$.  The maximum loss he can have on such a trade is therefore the premium. As you can see options trading can give limited downside. Let's look at what it takes for the trade to be profitable:

 

Phil has paid 7$ per. an option contract, which has a strike price equal to 110$. The underlying price of the instrument was in this imaginary case set at 100$ when he bought these contracts. This means that he must have the price of the underlying instrument at 117$ to not lose money on the trade. Anything above 117$ before the expiry date will give Phil a profit, and the option contract will go to ITM (In The Money).

Long-Call-Options-Trading-Example.jpg

Source: optionsbro.com

As you can see from the image above and as explained earlier, the maximum loss Phil can receive is the option premium +  brokerage.

The trade has in theory an infinite upside, and he will have a profit when the underlying price of the instrument is above 117$. An important thing with options is to get the timing right on the expiry date. This is because the contract expires worthless if the news and the increase in price come after the expiry date of the contract. It is therefore very important that Phil has set the expiry date based on his expectations of when he thinks the company's news will come.

Estimates of the imagined trade

 

Let's say that the underlying share price of the options contracts Phil bought has moved to 143$ before or at the expiry date. In the calculation below, we will have a look at what profit Phil would receive for the trade-in in such a case:

Premium = 7$

Strike price = 110$

Underlying share price at redemption = 143$

Contracts = 5

Calculation:

Underlying - Strike price - Premium = 26$ profit per. contract.

 

Profit:

26$ x 500 shares = Phil will in this case have 13,000$ in profit without counting brokerage fees.

 

Call options can in some cases be a lucrative and great way to get involved in a trade. It is also a good way to reduce the downside risk.  The downside risk of buying pure option contracts is always limited to the premium only.

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