lystn

Hey everyone. This is Kirk here again at optionalpha.com and welcome back to the daily call. It is very early in the morning, so if my voice is raspy, I apologize, but my kids are sleeping. I usually record these in the morning anyway and today, I want to spend a little bit more time talking about a long call option strategy and just the basics around what a long call option strategy is. When I think about options trading, I think about options trading being building blocks. If you're a science guy or if you understand science or maybe way back when if you go back to your science class in high school, I think about long calls and long puts as basically those first elements on a periodic table of elements, helium and hydrogen. That’s what they are. They’re building blocks that we then start building other strategies off of or start using. When you first get started at options trading, you might first learn about a long call option strategy because it's the best transition or the easiest transition from stock trading typically to options trading. It’s the simple bridge if you will from one system to another. Let’s go through the basics of what a long call option is. A long call option is basically a leveraged position in stock. That’s the first thing you have to understand, is you’re now using options to leverage the purchase of stock. The way that you do that with a long call is you are buying the right to purchase stock at some point in the future at a predetermined price. I’ll say it again. You’re buying the right to purchase stock at some predetermined point in the future at a predetermined price. The predetermined point in the future is the expiration date and that holds true across any option contract you trade. There’s going to be an expiration date that that contract basically expires and that's the point at which you either have to decide theoretically if you wanted to buy the underlying shares or not. Now, most of the time, we do not ever deal with the underlying shares. We can sell the contracts back. We can buy and sell the contracts in the open market. We don’t necessarily have to deal with the underlying shares. But the thought process behind it and the real mechanics of it if you did take it all the way to the expiration date is that’s the day that which you have to make a decision. Do you want to own the stock or not? Now, the predetermined price is called “your strike price.” This is where you… I always think about it as “strike a deal”, like where are you determining what the line in the sand is going to be between you and the option seller. If you’re buying a long call option for example, let’s say the stock is trading at $100 a share. You might buy a long call option at a 105 strike price for the next 30 days. Basically, your contract expires in 30 days and your strike, the price at which you are willing and have the right to buy shares is 105. Let’s think first before we get into the discussion of adding premium to this. Let’s think about it on its basic terms here, what you would do in the future. If your contract gives you the right, but not the obligation, meaning you have the choice to buy shares or not, then at expiration, everything is going to deal with where the stock is in relation to your strike price. For example: Our scenario here is that the stock is trading for $100 and your strike price is 105. If at expiration, the stock is still trading for $100, you probably would not exercise your contract because you have agreed to buy stock at 105 from the option seller, but the reality is that you can cheaply buy it in the market relative to your strike price. You can buy a stock in the open market for $100 a share because that’s where the stock ended at expiration. In that case, you would not exercise your contract. Your contract would expire worthless to you, the option buyer. If at expiration, let’s say though that the stock is trading at $110 a share. This is where now you can see potentially the power in using options because you have the right to buy options at 105 and you could buy them from the option seller at 105 and then sell them in the open market for $110. If the stock is $120 or $150, it doesn’t matter how high it goes. You have the right. Again, not the obligation. Your choice. But you have the right to buy stock at 105. In any scenario where the stock is generally higher than the strike price, you would exercise your contract and buy a stock or sell back the value of the contract in the open market. That’s pretty simple. On the outside, it's pretty simple how this works. The reason that people like this strategy is because it's leveraged, meaning that you can control 100 shares of a stock for a couple of hundred dollars versus actually having to buy 100 shares let’s say $100 apiece. That’s capital intensive to actually buy the stock. If the stock actually goes down in value, then your risk is limited to the premium that you paid for that contract. Let’s now start talking about that premium that you might pay for an option contract. We know that obviously, there’s value in leverage. That's why you have to buy these option contracts at a predetermined value in the open market. What do I mean by this? What I mean is if you have this ability to have this potentially big upside profit potential with limited downside risk, you can’t get that for free. You can’t just get an option contract and then control the shares. You have to pay a premium for that right that you are buying. You’re buying a right, you’re buying basically a chance at having a big upside payout if the stock continues to move higher and that premium cost money. In this case, let’s say that that premium for this call option that we were talking about in our scenario, (the stock trading at $100) you buy the 105 strike price. Let’s say that premium is $3. Now, it’s $3 of option value. That’s how options are priced or priced in basically dollar value, it’s like $3. But in notional terms, that’d be about $300. What happens with option pricing is that it shows you the price… It’s basically a per share price. You’re paying $3 per share versus $100 per share to buy the stock outright. If you times it by 100 contracts because each option contract controls 100 shares, anything that shows 3.00 is going to be $3 of option value, but it's really $300 of notional value out of your account. Just so we’re clear on how that works. Again, the stock is trading at $100, the strike price of our long call option is 105 and the premium that we have to pay upfront right now is $3 in our account. Now, this changes the dynamic of where and how you make money because now, if you add this premium to the strike price, ideally, you actually need the stock to trade above 108 for you to breakeven on your investment. If you think about it that way, now we have a change in dynamics. Even though you were buying the 105 strikes, because you paid a value to get into those contracts, we have to add that cost, that transaction cost to your breakeven PaL graph to get a value of 108. The stock has to go above 108 for you to make money after the cost of the long call option. Let’s run through a scenario here, so that it makes more sense. Again, let’s say the stock goes from 100 to 107. The stock is now trading at 107, 30 days later at expiration. Your long call option gives you the right to buy shares at 105 which was your strike price. You could buy shares at 105 and sell them in the open market for $107 and that’s where you get a $2 profit per share. But remember, the cost to get into the contract in the first place was $3. It cost you $3 to get into the contract and you could sell the shares for a $2 profit in the open market. You still didn’t make money until the stock gets above 108 because at above 108, you can sell the shares in the open market and generate a profit that’s higher than the cost to get into the contract. Hopefully that makes sense as you’re going through it here. Again, if you’re totally new to options trading, this is your first maybe experience with options trading, I highly suggest you look at an option strategy PaL diagram like the ones that we have on Option Alpha for this. You can just search “long call option” and you'll see how this PaL diagram works because you just want to look at the graph and you’ll see. “Okay, I get it. We have to add the premium to our strike price to get our breakeven point.” Now, let’s talk about the downside of all this stuff. The reason that long call options and just options in general, that people like to trade them is because they have limited downside risk. Let’s use an example again with our scenario that we’ve been working around. Let’s say the stock starts at $100, but now it trades all the way down to $95. It goes down by $5. You thought it was going to go up, but it actually went down by $5. Well, your long call option that you got into gives you the right to buy a stock at 105, but you’re not going to do that because if you truly wanted the stock, you would buy it in the open market for $95 versus overpaying by $10 and buying it from the call option seller for $105. What would you do in this scenario? In this scenario, you’d let your contract expire worthless. That would be the most cost-efficient, economically efficient thing for you to do. Now, in that case, you’re still going to lose $3 of premium that you paid to get into that contract, but you can never lose more than that $3 premium because again, remember, this is your right as an option buyer. You can choose to exercise or not, but in either case, you basically lose that premium that you paid. In this case, if the stock is trading at $95 and you lose that $3 premium, that's better than if you had been long stock at $100 and lost $5 in value. Imagine that you actually had bought the stock versus buying the option. If the stock went down $5, you actually lost $5 per share. With the option contract, even if the stock goes down $15 or $20, you only lose the premium that you paid for that option contract. Whatever that premium is, that's what you would lose. If the premium was $4, you’d lose $4, etcetera. That’s why people like it. People like it because it has limited risk and it has a lot of upside potential. Everything seems really great at this point. If you’re probably listening to this before, you’re like, “Wow. This seems like it’s a no-brainer. It seems like it’s a no-lose situation.” Let’s talk about the downsides of doing a long call option. The biggest downside obviously is the fact that the market knows that you have this embedded premium risk reward ratio, meaning that you have this huge upside potential with very limited downside risk. We all know that markets are pretty efficient. You can’t get a free lunch in any market, meaning you can’t take on a free trade like this or a seemingly free trade where there’s an unbalance of risk and reward. What happens (most people don’t understand this) is that your probability of success with long call options is diminishing the further and further you go out of the money. As you start buying options that are let’s say at a $105 strike price, then $110, then $115, the probability of actually seeing the stock go to those levels goes down and down and down and down. There’s a lower chance that the stock goes to 115 than 105. It seems logical on the outside. The market prices that expectation into the option premium that you pay. That premium that you pay always moves your breakeven point just far enough out that consistently buying long call options ends up being a losing strategy. I’m not saying that it’s not going to be potentially profitable in certain scenarios. But as a consistent and religious way to buy options, we know from all of our back-testing and all of our research, as well as any other person that you search online… You can search this online. You can see the same results. A consistent long call option strategy ends up being a losing strategy because you pay more premium than how far the stock actually moves every month. It seems like the premium is always just a little bit more than how far the stock moves. You need to get a stock that might consistently outperform which is very hard to do and practically impossible for this thing to work out. Now again, the reason that we talk about it here on the podcast is because I want you to know how the basics of a long call work because it is a building block that we can now use in future episodes to start building and adding trades together, to start piecing different portions of option trades together. But if you understand how long call works, then it’s very simple to start understanding how the other strategies work and how we can put them altogether basically in a sense. Hopefully this helps out. I hope you guys enjoyed this little podcast. This is a little bit more of a basics episode today and definitely a little bit longer than what we typically do, but I think it was really enjoyable. Again, if you know somebody who’s starting to get into options trading and think this episode might help out, please, as always, share it with them. Help us spread the word about what we’re trying to do here at Option Alpha. Until next time, happy trading!