Long calls
This chapter covers the fundamentals of long call options contracts. To gain a good understanding of the language used when discussing options, watch this video:
When an investor goes long a call, they are bullish on the underlying security’s market price. Purchasing a call provides the right to buy stock at the strike price. If the stock’s market price rises above the call’s strike price, the holder can potentially make a profit (“call up” - the call is “in the money”). If the market price falls below the strike price, the holder will not exercise the option and realizes a loss equal to the premium (the call is “out of the money”).
Let’s work through a few examples to understand long calls better:
Long 1 ABC Sep 75 call @ $6
This contract provides the right to buy ABC stock at $75 per share. The option costs $600 and expires on the third Friday in September. The investor is betting ABC stock’s market price rises above $75 before expiration. Otherwise, the option will expire, resulting in the investor paying $600 for a contract they never used.
Math-based options questions should be expected on the exam. Normally, they involve potential gains, losses, and breakeven values. Let’s go through each.
A long call’s maximum gain is unlimited. The contract cited above allows 100 ABC shares to be purchased at $75 at any time before expiration. The further the market price rises, the more the shares can be sold for after exercising the option.
For the following examples, assume the investor sells their shares immediately after exercising.
An investor goes long 1 ABC Sep 75 call @ $6. The market price rises to $100. What is the gain or loss?
Can you figure it out?
Answer = $1,900 gain
| Action | Result |
|---|---|
| Buy call | -$600 |
| Exercise - buy shares | -$7,500 |
| Sell shares | +$10,000 |
| Total | +$1,900 |
The market price went to $100 and the option went “in the money” by $25. The investor exercised their contract, buying 100 shares for $75 per share, then immediately sold them in the market at $100. The option’s strike price of $75 is fixed, but the market price is not. The further the market price increases, the higher the liquidation (sale) value.
While the maximum gain is unlimited, long calls don’t always end in profit. Even if ABC’s market price rises past $75, the investor may not make enough to cover the premium.
Let’s try another example with the same option:
An investor goes long 1 ABC Sep 75 call @ $6. The market price rises to $81. What is the gain or loss?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Buy call | -$600 |
| Exercise - buy shares | -$7,500 |
| Sell shares | +$8,100 |
| Total | $0 |
At $81, the contract is $6 “in the money.” The option gained intrinsic value, but didn’t make enough money back from the exercise to profit. The exercise resulted in a purchase of 100 shares at $75 with a subsequent sale at $81, netting the investor a $600 gain. However, the $600 premium paid upfront offsets the gain, and the investor breaks even.
When investing in calls, the breakeven can be found using this formula:
With a strike price of $75 and a premium of $6, the investor breaks even when ABC stock is at $81 per share. At this market value, there is no profit or loss.
If ABC’s market price doesn’t rise enough past $75, the investor could also be stuck with a loss. For example:
An investor goes long 1 ABC Sep 75 call @ $6. The market price rises to $79. What is the gain or loss?
Answer = $200 loss
| Action | Result |
|---|---|
| Buy call | -$600 |
| Exercise - buy shares | -$7,500 |
| Sell shares | +$7,900 |
| Total | -$200 |
At $79, the contract is $4 “in the money.” Although the option has intrinsic value, it wasn’t enough to offset the premium. The exercise provided a profit of $400 as the investor purchased 100 shares for $75 and sold them for $79. However, the $600 premium paid upfront resulted in an overall loss of $200.
Expiration is the worst-case scenario for investors holding long options. When this occurs, the investor pays a premium for an option that is never used. The same applies to long call contracts.
An investor goes long 1 ABC Sep 75 call @ $6. The market price falls to $73. What is the gain or loss?
Answer = $600 loss
| Action | Result |
|---|---|
| Buy call | -$600 |
| Total | -$600 |
At $73, the option is $2 “out of the money” with no intrinsic value. When the market price is below $75, there is no point in exercising the option. Why would the investor exercise and buy stock for $75 when the market is trading the stock for $73? Therefore, the investor lets the contract expire and realizes the loss of the premium (their maximum potential loss).
Long options can only lose the amount spent on the premium. If exercise will result in a loss, the investor will let the option expire.
Investors can also perform closing transactions to close their options before expiration.
An investor goes long 1 ABC Sep 75 call @ $6. After ABC’s market price rises to $79, the premium rises to $9, and the investor performs a closing sale. What is the gain or loss?
Answer = $300 gain
| Action | Result |
|---|---|
| Buy call | -$600 |
| Close call | +$900 |
| Total | +$300 |
The market price increased, resulting in the option premium rising as well. Remember, premiums are not fixed and constantly fluctuate like stock prices. The premium was $6 when the call was originally purchased. Later, the premium rose to $9, the price achieved when the call was liquidated (closing sale).
The investor bought the call for a premium of $6 and sold it at a premium of $9, resulting in a $3 per share gain. With option premiums representing 100 shares, the investor makes a $300 profit. To find the profit or loss for closing transactions, compare the price paid for the option to the price sold.
Here’s a visual summarizing the important aspects of long calls:
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