Long Call Strategy

The long call option strategy is perhaps the most commonly used and often is the most commonly misused as well. On the options basics page, I talked about why this strategy is risky, however it doesn't always have to be that way. I will actually look at two different ways to trade thist strategy.

Outlook/Analysis

To want to trade a long call, I must be bullish on the underlying stock, ETF or index. In fact, I typically want to be quite bullish or it may make sense to trade a different strategy, such as a short put vertical spread.

One thing I like about the long call strategy is that my risk is limited ultimately to the price I paid initially. I can certainly limit this further by using a stop loss. This strategy offers a nice amount of leverage since the cost is relatively small, yet I can take advantage of strong upside moves in the underlying.

Trade Entry


Selecting the right stock

For the long call strategy, I prefer to find stocks that have shown a history of sustained moves and may be also showing evidence of changing trends from bearish to bullish or resuming a previous bullish trend.

For the purpose of this discussion, I'll use AMZN, which has been in a pretty bullish pattern recently. It shows some evidence of strong moves when it does move up.

AMZN long call example

AMZN recently closed at $62.35 and looks to be forming a bull flag. As a result, I might expect a further movement at least to $67.50 or even a breakout to new highs.

Timing the entry

Since the long call strategy depends on a strong, relatively quick move up AMZN long call technical entryin the price of the stock, I prefer to catch the stock near a support bounce or right as it breaks through a previous resistance point.


Notice though that the previous bounce was leading up to an earnings announcement... not a good time to be in a trade.

Selecting the right options

Before placing the trade, let's first do some analysis of various trading approaches. I mentioned earlier that I would discuss two different ways I trade a long call. One is deep in-the-money (ITM) and the other is out-of-the-money (OTM). On the previous page, I briefly showed an example of trading an OTM call, but I want to go into more analysis detail here.

OTM strategy
With the OTM strategy, the idea is to purchase an inexpensive option with no intrinsic value and very little time value. The money is made on a rapid move of the stock that either causes the time value component to rise quickly or by causing the option to become ITM.

For this example, I'll chose the March 70 call option, which is currently trading for about $1.57. The first thing to realize is that to break even on expiration day, AMZN must be at $71.57. However if AMZN were to make a swift move up to even $67 in the next few weeks, I could expect to realize a profit on the option. In fact even if the volatility of the option drops 5% over the next two weeks while AMZN moves up to $67, I could realize a profit of $.18, which translates to an 11% return (I'll talk more about calculating returns in a bit).

AMZN OTM long call trade

What is the risk of this trade? AMZN may not move up much at all over the next 2-3 weeks and you watch the time value of your option melt away to practically nothing.

ITM strategy
For the ITM strategy, I like to choose an option that is in the money at least several strikes. I'll typically choose a call that has a delta of around .75-.90. The $50 call has a delta of about .86 right now and trades at around $13.20. "Wait a minute", you say, "That's a really expensive option!"

AMZN ITM long call trade

Yes - that is true. But I'll offer two other things to look at. First, if I were to buy the stock, it would cost me $62.35 per share. How much for 100 shares? About $6235. If I were to buy the $50 call, which controls 100 shares of AMZN stock, it would cost $1320. With a delta of .86, I am benefiting from 80% or more of a bullish move on AMZN.

The second point I want to make is regarding the time value of the option. With the OTM option, the entire premium is time premium. With the $50 call, only about $1.08 of the total premium is time premium. That means if AMZN goes nowhere (one of the risks I talked about in the OTM strategy), I'll only lose about $1 of my $13 investment. But... if AMZN moves up to $67 as expected in the same 2 week time period with the same expected 5% drop in volatility, my option will be worth $16.85... a 27% return.

Why is this appealing to me? First because I am less impacted by the passage of time and changes in volatility. Second because there is less risk if AMZN goes nowhere for the next two weeks.

Analyzing risk/reward

Before placing any trade, it is important to analyze risk and reward. If the risk is too great for the expected reward, then it doesn't really make sense to take the risk.

Long Call P&L graph
For a long call, the way I analyze my risk vs reward is to look at my projected outcomes, both ideal and worst case. What are my exit points for the trade?

For my best case scenarios, I'd project a move to at least $67 in the next two weeks. A failure to do so would indicate my analysis is wrong based on the behavior of a bull flag pattern. From the best case scenario, I also need to determine the projected option price. This can be done several ways, but the simplest (but least accurate) is to use delta.

With my OTM option having a delta of about .27 and projecting a move of $4.65 ($62.35 to $67), I might expect the OTM option to increase $1.25... but that assumes not much erosion of time value and very little change in volatility.

A similar approach can be used for the ITM option. This option has a delta of .86 so I'd expect an increase in the option value to be around $4.

What is the worst case scenario? One case would be for AMZN to go nowhere for the next 2-3 weeks. Another would be for it to drop to say $57.50 or so. How will that affect my options?

For the OTM option, I'll see it potentially decrease to about $.18, which means I've pretty much lost the entire investment. Can I tolerate that? Depends on your position size right?

What if I used a stop to exit when I lost only 50% of the value? That would be around $.78 risked for a potential reward of around $1. That's a 1.28:1 reward/risk (1/.78).

With the ITM trade, if I assumed the same move of AMZN potentially down to $57.50, my ITM option would be worth approx $8.26, which means I lost about $5 or about 37% of my investment. So in this case, my reward/risk would be $3.65/5 or .73:1... potentially not too good unless I was right a lot with this strategy. And... with the long call strategy, I'm not right as often as I'd like.

Placing the order

Once I've selected my option, it's time to place the trade right? Whoops! How many contracts will I buy? That will depend on how much I am willing to risk.

You must decide BEFORE placing the trade how much you are willing to risk.

That plus the choice of option and my exit strategy will help determine how many contracts to buy.

In this example, for this trade, I am willing to risk $1000. Further, I will allow a stop loss on the option such that I exit if my option value drops to 50% of the original purchase price. That means $.78 for the OTM option and $6.60 for the ITM option. Knowing that 1 option contract controls 100 shares, my calculations would be:

OTM: $1000/(.$78 x 100) = 12.8 or 12 contracts. However, 12 contracts will cost $1884.

ITM: $1000/($6.60 x 100) = 1.5 contracts ... or 1 contract. One contract will cost $1320.

OK. I know which option I will buy, how many contracts and at what price I'll exit. I must be ready to place the order.

Some online brokers designate opening orders differently than closing orders. To open the long call trade, I might place the order as 'buy to open' 12 contracts of the March 70 call for an offer price of $1.57.

Trade Exit

As I mentioned, I want to make sure I have determined in advance what the exits are for this trade. For a long call trade, I like to have three key exits planned.

  • When will I get out if the trade goes as planned?
  • When will I get out if the trade goes against me?
  • How much time will I allow for the trade to develop?

This last one puts a time constraint on the trade that allows me to exit a trade early if the pattern I expect doesn't develop.

For the first two, I have already determined to use a 50% stop loss for the worst case scenario. If the trade goes as expected, I may simply chose to close the trade when AMZN reaches $67.

Many online broker platforms allow you to place a 'one cancels other' order such that you can place both orders simultaneously - one to get you out with a profit and one to get you out with limited loss. With this kind of order, whichever order gets hit first, the other will be canceled.

I've learned the hard way that the best way to consistent profits is to have a process I follow consistently. This is true for a long call or any other strategy.

Summary

With the long call strategy, it is possible to make money from a strong bullish move of AMZN. Because of the leverage options offer, I could realize a better gain from an options trade than with stock. However, leverage goes both ways. Time is against me with a long call.

Notice that as I've discussed the various steps to trading the long call, I've followed a fairly structured approach (selecting the right stock, timing the entry, selecting the right options, entry, exit, etc). These are based on a set of trading rules I follow, which are part of an overall option trading system I follow. This is a critical aspect of successful options trading. I've found I can't be successful trading any strategy just by knowing the mechanics. Having a system that defines what I do every time I trade is what helps me be consistent in my profits.

Outlook: Near term to medium term bullish
Max profit: Unlimited
Max Loss: Cost of the option (but you can limit with a stop loss)
Net Position: Long
Time decay effect:  Works against you



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