Long Call Option: When To Create It, and Key Things to Remember

The entry-level strategy for many traders is the long call strategy. Listening to stories like how a friend, or his friend, bought a call option and then multiplied his money many times over in a short period of time is what brings a cash market trader into the options market. The potential of winning the lottery ticket by buying options more often than buying the real lottery is what brings retail traders to the option buying market.

Before looking at how one can trade a call option, let’s get our basics in place.

What is a call option?

A call option gives the buyer the right, but not the obligation, to go long on an underlying asset at a certain price, called the strike price, on or before the expiration date. If the underlying price increases, so does the value of the call contract. Conversely, if it goes down, the price of the call option decreases.

In order to buy the right, the buyer of the option pays a premium to the seller of the call contract. The buyer of the option can close his trade at any point in time by selling the option in the market or allowing it to expire worthlessly.

We have already touched upon the basics of a call option earlier. Here, we will point out that the buyer of a call option needs to keep in mind three important points before entering the trade.

The first is the Strike price, which is the pre-determined price at which the underlying asset will be exchanged. The second is the Expiration date or the date at which the contract is settled or expires worthless.

Finally, the Premium Paid for buying the option has to be considered.

Payoff diagram of a Long Call Option

Nifty is trading at 18812, and a Long Call trade is taken by buying a 19000 call for the 08 DEC 2022 expiry.

Since the market is trading at 18,812an and 19,000, Call is an out-of-the-money (OTM) option.

The premium paid for creating the position was Rs 49, and the value of holding the position is Rs 2450.

The maximum loss to the trader in creating the position is Rs 2450.

The trader will achieve breakeven when the market crosses the strike of his option plus the cost of buying the call option.

Breakeven = 19000 + 49 =19049

When to create a Long Call position

A trader will create a Long Call trade when he expects the underlying to be bullish.

The general perception in the market is that option sellers make more money than option buyers. This is both a right and a wrong statement.

Indeed, it is true that option sellers are correct in their trades more often than not. That’s because even if the market does not move in the direction of their call, it will be profitable for them because of the characteristic of an option losing its value over time.

This restricts the situations under which Long Call Option trades can be created.

Traders can open Long Call trades when they are expecting a sharp move in the underlying. This is one of the reasons why most traders take Long Call trades on an intra-day basis or in what is called a Buy Today Sell Tomorrow (BTST) trade. Exposure to the market for a short time has a limited effect on option decay.

The Long Call strategy is preferred by scalpers and momentum traders who are in the market for a short duration of time.

Professional traders prefer taking Long Call trades when volatility is very low. When the Implied Volatility Percentile (IVP) or the Implied Volatility Rank (IVR) is very low, they create Long Call trading positions.

Which Call Option to buy

A long call strategy can be created by taking a position in any call option strike. Many retail traders make the mistake of buying a Deep OTM call because it is cheap. However, for this call to make money for the trader, the market has to move a long distance fast before the trade becomes profitable.

The selection of the strike is an important factor to consider to make the Long Call trade profitable.

If the trader is expecting a surprise, only then does it make sense to take a position in a Deep OTM strike, else an at-the-money (ATM), or a slight in-the-money (ITM) or a slight OTM strike is good enough to create the position.

Factors to consider in selecting the Call option strike price

Impact of underlying price change

A Long Call trade theoretically has to move in line with the underlying. However, this is never the case. The relationship between the underlying and the call option loosely depends on the value of the Options Greek called Delta. Thus, if an option has a Delta of 0.20, then for every 100 points move of the underlying, the option will move by 20 points.

Depending on the distance the trader expects the market to move, he can select the option strike price and pick up the one offering an optimum return.

Impact of volatility

When it comes to buying options, volatility is a friend. A rise in volatility will increase the price of the option. As discussed above, traders prefer to enter a Long Call trade when they see that the volatility is near its lowest point in a year.

Impact of time

Time is an enemy of the option buyer. With time the value of the option deteriorates. Thus, a Long Call Option trade can be taken when the trader expects a sharp price burst. The Long Call trade can end up in a loss even if the direction is right but has failed to cross the breakeven point by the time of expiry.

Impact of stock price change

Call prices, generally, do not change rupee-for-rupee with changes in the price of the underlying stock. Rather, calls change in price based on their "delta". ATM calls typically have deltas of approximately 50%. So, a Re 1 rise or fall in stock price causes an at-the-money call to rise or fall by 0.50 paise. ITM calls tend to have deltas greater than 50% but not greater than 100%. OTM calls tend to have deltas less than 50% but not less than zero.

Impact of change in volatility

Volatility measures how much a stock price fluctuates in percentage terms. Volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors, such as stock price and time to expiration, remain constant. As a result, long call positions benefit from rising volatility and are hurt by decreasing volatility.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. Long calls are hurt as time passes if other factors remain constant.

Things to remember

A call option gives the buyer the right, but not the obligation, to go long on an underlying asset at a certain price, called the strike price, on or before the expiration date. If the underlying price increases, so does the value of the call contract. Conversely, if it goes down, the price of the call option decreases.

A trader will create a Long Call trade when he expects the underlying to be bullish.

Volatility is a friend of options traders. A rise in volatility will increase the price of the option.