Buying a Call Option – Part 1/2
The LONG CALL is one of the 4 basic option trading strategies and it has a bullish bias that creates an unlimited reward position with limited risk exposure.
Example: Let’s say you are bullish on Apple (AAPL) and believe that it will rise to $230 by Jan 2010. To take advantage of this move, you decide to purchase a CALL option. With AAPL currently trading at ~$200, you analyze the option chain (calls on left and puts on right) and decide to purchase the Jan 220 call. The option premium for the long call is $4.35 and your trading platform should automatically debit $435 from your account.
The LONG CALL option has the following characteristics:
- Maximum Reward/Profit = Unlimited
- Maximum Risk = Debit Paid to enter position
The unlimited reward potential is possible because AAPL can run to $300 or even $500, but the call option gives you the right to purchase it for $220/share, making the option worth a lot of $$. ***This does not mean you have to buy AAPL stock; you can just sell the call option and take your profits.
On the other hand, if AAPL does not trade above the strike price of 220 by expiration, then the maximum you have lost is the debit you paid to enter the trade. If you think that AAPL is not going to trade above $220 before expiration, then you can sell the call option and salvage any remaining value. You do not have to let it expire worthless!!
Remember that at expiration, an option only contains intrinsic or “real” value, thus AAPL must close above $220 for the position to start making money. I purposely said “start making money” because the position will only profit once you have recovered the option premium paid. Therefore, the breakeven point for this position is $224.35 and AAPL will have to close above this point for you to turn a profit.
Breakeven = Strike Price + Option Premium (220+4.35=$224.35)
By buying a CALL option, you entered a bullish trade in AAPL that has an unlimited reward potential with limited risk for a fraction of the cost.
Continue reading “Buying a Call Option – Part 2/2” to look at the risk profile, a graph that shows Profit/Loss for the position at expiration.
