3/23/22, 11:14 PM Lesson 6: Buying Long Call Options

Introduction to Stock Options / Lesson 6: Buying Long Call Options

/ Lesson 6: Buying Long Call Options

Lesson 6: Buying Long Call Options

We're at Lesson 6, the halfway point in this course. Congratulations! You deserve a pat on the back for
your progress.

You've learned a lot in the last five lessons and equipped yourself with many of the tools necessary to
trade options successfully. From now on, the lessons will focus on how to use these tools to create
profitable option positions for market movement—in any direction. We'll introduce you to the real world
of option trading and, more importantly, option strategies. Finally, this is the part you've been waiting for!

Now, one thing to remember is that there isn’t a good, or bad, option (or any investment, for that
matter). It’s all about what’s going to work for you. Do you want to take an offensive position and attack
the field, or would you rather defend what you’ve got and take a protective position? It’s up to you! We’re
going to give you a lot of things to consider so take the knowledge and information and make it your
own.

Stocks Versus Options

We told you buying an option wasn't so different from buying a stock. They're both listed securities, and
you go through a broker to buy either one. In fact, some of the same exchanges that trade stocks also
trade listed options. There are important differences, though.

Now that you know so much more about options, we can elaborate on the similarities and differences
between options and stocks.

On the similar side, options and stocks trade between what we've come to call the Bid Guys and Ask Guys;
these could be large financial institutions, market makers (the professional exchange-floor traders who
play Bid Guy or Ask Guy), or savvy individuals like us.

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Unlike stocks, each option represents the right to buy or sell 100 shares of the
underlying stock at a specific price for a specific time. Unlike options, shares of
stock don't expire—though many people have owned a few that may as well have
expired!

Just remember, options are wasting assets. And wasted assets don’t last forever;
you have to use them or lose them within a certain period. It's sort of like that
circle game where you keep passing the ticking time bomb to your neighbor.
Eventually, time expires and… kaboom!

There's another interesting and important difference between stocks and options. Stocks represent
ownership in a company and have strict rules attached to them. The Securities and Exchange Commission
allows each company only a certain number of stock shares according to their incorporation documents,
and a company cannot easily change the number of shares available. (It happens sometimes, mind you,
and you see it when a stock splits.)

The owners of stock shares, whether large financial groups or investors like you, also have certain rights in
that company. They can vote for directors and on various issues affecting the company, and they often
receive dividends when the company's doing well and decides to pay them. If you want, you can even
receive a fancy stock certificate (suitable for framing) that shows how many shares of stock you own.

Options, on the other hand, have no certificates. All you get with option
contracts is what ends up printed on your brokerage statement or listed
online where the transaction or your holdings are recorded. Owning
options won't entitle you to vote as a company stockholder. Options don't
reward you with any dividends, although the option premium may
fluctuate when the company pays dividends. There are trade-offs here, as
you can see.

You'll see in future lessons that option contracts come into existence when a buyer agrees on a certain
price and terms with a seller. There's no fixed number of option contracts. There can be as many options
as there are buyer-seller transactions—as indicated by open interest. Hopefully you still remember open
interest and know how to find it on an option listing.

Advantages of Options
So, what do you get with options that make them so special? There are a few
unique advantages, and they include:

Limited risk

Leverage

A standardized market within the rules of the Options Clearing Corporation

(OCC)

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Flexibility

We've mentioned, or at least hinted at, all these advantages before but let’s briefly review them again.

Loading flashcards...

These are just a few of the neat things you can do with options… things that demonstrate an option's
flexibility.

Spotlight on Buying Call Options

With Lesson 6, you begin a whole new phase of this course. From now on, we'll concentrate on this
flexibility by spotlighting certain basic strategies. With each strategy, you'll become acquainted with more
of the necessary concepts, jargon, and procedures. And we'll take time to address your questions and
concerns. In short, we’re going to show you how to trade options.

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Don't worry. We’re going to start this process with a familiar friend… buying a call option. We just
mentioned jargon, and here's a bit of it for you now. When you buy an option, you'll often hear such a
position referred to as long because you actually hold the option after a trade transaction. It's a little hard
to explain without discussing the opposite of a long position, which is a short position. That's when you
sell an option and, thus, you hold no option after a trade transaction. But let's save the short positions for
next lesson. We want to spotlight a long position now, one that involves buying a call option.
Okay, option detective, why on earth would you ever buy a call option? It's a basic question for which there
are many answers. Remember flexibility? Let's examine a few more reasons.

Reason 1: To Participate in Upward Price Movement

Let's say you have a good feeling about the Rabbit Ears Company, or REC. You know their new gadget is
going to be a hit, and you want to make some money if the stock shoots up. REC stock currently sells for
$40 per share. If you wanted to pick up a couple hundred shares of REC stock, it'd cost you $8,000 plus
commission and fees. That's a lot of money, plus you don't necessarily wish to own REC shares anyway.
No, you just want to make some money as the share price, hopefully, goes up over the next couple of
months.

So instead of buying the stock, you decide to buy two call options with a strike price of $40 that expires in
60 days. You go online and find out each option's selling for $2.50. That, of course, means you pay $500
plus commission and fees for the right to purchase 200 shares of REC over the next 60 days. Are you still
with us?

Okay, what if REC goes up to $53 a share after three weeks? You look at what your option's selling for and
discover it's now worth $15.60. If you figure this is about as far as you can reasonably expect REC to
appreciate, you have two choices. Take a look below at what you can do.

Text equivalent start.

Topic Information

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Topic Information
Exercise Your Options Exercise your options, in your case, that you
want to use your two options to buy 200 shares
of REC stock at the contracted strike price of
$40. So that's 200 times $40, or $8,000, for the
stock that would cost anyone without options
like yours $10,600. If you wanted, you could
turn around and immediately sell the stock for
$10,600. Or you could just hold on to the stock
indefinitely.
Close Your Option Position In this case, closing your option position means
you would sell your two options for $15.60. That
means, ignoring commission costs, you collect
$3,120 for options for which you paid only
$500. Not a bad return, huh?
Read the topic in the first column. Then read the second column for the information.

Text equivalent stop.

Please Note…
The $15.60 is an example. The actual price, as you know, would be determined by the
spread. We know that movement of an underlying stock, like this, would cause the
option to be more valuable when it is ITM and closer to expiration.

Unless you really wanted to own the stock itself, closing the option position is the way you'd normally
proceed. At expiration, there's no advantage to exercising your options and selling the stock right away
versus just selling your options. If, as in this example, there is time value remaining, selling the option
would be slightly more lucrative.

This strategy of buying call options is the most cost-effective way to take advantage of any anticipated
market advance. Because of the leverage options offer, options are the way to go if you have a strong
sense of where almost any market's going. You'd enjoy a huge advantage buying as many call options on a
stock as you could afford versus buying the actual stock. You'd stand to make a lot more money and be
able to do so by using a lot less of your money up front. And that, after all, is the name of the game here,
right? This would be if we just want to make a profit. Buy low… sell high!

Reason 2: To Lock in a Stock Purchase Price

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In this call option strategy, you see a stock, like REC, selling for an attractive price. Let's say REC's selling
for $20 a share, and you think it won't stay at such depressed levels for very long. You want to buy 1,000
shares of this stock, but you don't have $20,000 lying around just now. In fact, you won't have that kind of
money until your year-end bonus check comes in. That won't be for another four months. But you're sure
REC won't be selling for $20 in four months. You think that it'll appreciate 25% to 30%, and you would
sure hate to miss out on REC stock at this bargain-basement price.

Ah, but with options, you can lock in that great $20-per-share price right now for a reasonable amount of
money. If you were to buy 10 REC call options that expire after your bonus check is supposed to arrive,
you'd have the right to buy REC stock for $20, no matter what it's selling for—anytime over the next four
months.

Of course, this privilege of locking in on REC's share price isn't free. You'd pay a premium of, say, $2 for the
options. But if you’re right and REC stock really takes off, the estimated $2,000 cost for 10 at-the-money
call options is a modest price to pay for this valuable privilege.

If your hunch is wrong and REC stock drops instead, your loss is limited to the actual cost of your 10
options. You might lose everything you invested, or you might be able to salvage some remaining time
value to your options by selling them in a timely manner. You have to weigh the risk of that happening
against all the positive vibes you have about REC stock.

Using options to lock in a good price for a stock you wish to own in the future is a powerful strategy, but
it's one that many investors overlook.

Reason 3: In Case of Continued Stock Gains

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Finally, what if you owned 500 shares of REC stock? Let's also say it had appreciated nicely to the point
where you thought it might be wise to sell the stock and take your profits. Sometimes this is difficult to do
because of the nagging possibility of your stock's continued upward climb. No problem! Sell the stock and
use a fraction of your profits to buy five options that'll continue to participate in any future upward
movement of REC stock—with a lot less risk.

So, there you have it: three reasons to buy a long call. But how do you know whether buying a call is a
good idea? In Chapter 3, we'll walk you through the decision process. Before moving on, let’s do a quick
learning check.

Learning Check
Text equivalent start.

Item to Match Matching Choices Correct Match

Can lock in a stock purchase Options Clearing Long call
price Corporation
Options
Limited risk
Long call

Can only lose what you paid for Limited risk Limited risk
the call option Options
Options Clearing
Corporation
Long call

Intermediary between buyers Limited risk Options Clearing

and sellers Options Corporation
Long call
Options Clearing
Corporation

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Item to Match Matching Choices Correct Match

Wasting assets Options Options
Limited risk
Options Clearing
Corporation
Long call

Instructions: Read the item in the first column and consider which choice(s) it matches to in the second column. Read the third
column to find out if you are correct.

Text equivalent stop.

The first step in deciding whether to buy a call is similar to the decision process you go through when you
buy a stock.

Why would you decide to buy a stock? Well, you must have some idea that it's going to go up in price. It
may be a hunch, or your research points to a bright future, or a coworker recommends the stock. The
bottom line, though, is you wouldn't be buying a stock if you thought it was going to go down. In fact, you
probably wouldn't even buy the stock if you thought the price would stay the same.

Now, let’s make one thing clear. We’re not going to tell you how you make up your mind a stock's share
price is going to go up. This is something you have to figure out on your own. Maybe you'll study the
financial reports of companies (fundamental analysis), or you'll spend hours poring over stock charts
(technical analysis), or a little of both. Or maybe you'll get a hot tip from Uncle Harry, or your horoscope
says something promising. It doesn't matter. It's whatever works for you. The point is you have to develop
a method—your method.

Again, we’re not able to tell you how to pick a stock that's sure to go up in price. But what we are going to
teach you is how to make a big profit on a stock that goes up in price. As you must suspect by now—you
do it by using options. Specifically, you buy (or go long on) call options.

Basically…

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It all boils down to this: if you're prepared to buy a stock because you believe its price
is going up, why not buy a call option instead and, potentially, make a heftier profit?

There's one extra consideration in your decision-making process. Can you guess what it is? It's our friend
—and occasional enemy—time. Before you buy an option, you have to have some notion of when the
underlying stock price is going up. You can base this on those stock charts, an upcoming earnings
announcement, a stock split—whatever! How quickly does this stock's price move historically and
compared to the market as a whole? By whatever means, you must decide what the likely timing of this
anticipated stock price move will be because timing is crucial.

To take full advantage of options, the stock price must go up in the next few months. If the best you can do
is hope the stock will go up in the next couple of years, you'd better stick to buying the stock. However, if
your charts, financial newsletter, Farmer’s Almanac, Ouija board, or whatever tells you a stock's going up
in the next few months… well, options are the perfect way to take advantage of that hunch.

So, to lay out the ground rules, you'd consider buying a call option when you strongly believe that a
certain stock is going up in price soon. And by "soon," we mean anything within the next week to eight
months.

Okay, enough caveats. You've decided a certain stock is going up in price by a sufficient amount soon. Let's
see how to maximize your profits by using a call option strategy.

Let's recall the generic profit-loss graph for buying a call option, just so you know what you're dealing with
here. This graph doesn't include the effect of time decay, but you know this is an added factor to consider.
Just to keep things simple, this graph reviews the properties of a call option and shows the situation on
expiration day.

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Examining this graph should help you remember those properties of a call option. You see limited loss,
unlimited gain, and break-even just a bit to the right of the strike price mid-point. What you're shooting for
here is to see the price of the stock far to the right on the graph before option expiration. When that
happens, you'll have strong intrinsic value, as indicated by the blue line, plus whatever time value may
remain in the option.

Okay, now you have in mind what it is you're intending to buy and how it'll react if the underlying stock
price goes up or down. It's always good to review a P/L graph to make sure you have a firm grasp on
precisely what you're buying.

After you've found an underlying stock that shows promise of going up enough in the near future and you
determine to buy call options, what comes next? You go online to consult an option listing. You've seen
them before, and you know how to read them. But there's a bit more to the decision-making process to
factor in, isn't there?

The problem is which call option to consider buying. Here's the next step in your decision-making process.
You have to ask yourself whether you're very bullish, bullish, or slightly bullish on this stock. What this
means is: How strongly do you believe the underlying stock is going up soon?

The answer to this question is critical to deciding which option to buy. We'll explore it in Chapter 4.

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Here are some scenarios to illustrate varied levels of bullishness. In each example, let's assume you have
around $500 to invest, and your option choices are according to the option listing shown here. This is a
three-month option listing for Rabbit Ears Company.

Move through the gallery by clicking either the right or left arrow. You can also navigate to a specific slide
by selecting the dropdown menu located at the bottom of the slide.

Slideshow Slide 1 starts here

Stock Op
Strike Last Bid Ask Vol Symbol
Series Int

REC $50.00 52395

January $45 $5.50 $5.40 $5.70 125 644 REC210122C00045000

$50 $1.75 $1.50 $1.80 290 4012 REC210122C00050000

$55 $0.25 $0.20 $0.40 488 1205 REC210122C00055000

February $45 $6.00 $5.80 $6.25 55 358 REC210219C00045000

$50 $2.50 $2.25 $2.75 125 752 REC210219C00050000

$55 $0.80 $0.50 $1.00 322 954 REC210219C00055000

March $45 $6.65 $6.50 $6.75 28 226 REC210319C00045000

$50 $3.25 $3.00 $3.50 95 620 REC210319C00050000

$55 $1.30 $1.20 $1.50 161 857 REC210319C00055000

Three Month Option Listing for Rabbit Ears Company

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Example 1: Very Bullish

Assume it's around January 4. Your research shows REC is going to introduce its new JackRabbit
service in the next two weeks, and you believe the REC stock price will jump at least 15%. Today,
REC is trading at $50. Which option should you buy, and why?

Well, if you're very bullish, you'd make the greatest profit by buying the near-term January out-of-
the-money 55 calls (REC210122C00055000). You can see from the price chart that these are
inexpensive calls. The premium's only 25 cents. But if REC goes up to $57.50 in the next two
weeks, these options can easily rise to $3. If you invest your budgeted $500, you can buy 20 call
options. In two weeks, if things go as hoped, you could sell these options for $3 each, for a total
of $6,000. This is a fantastic return on your $500 investment.

Slideshow Slide 1 ends here

Slideshow Slide 2 starts here

Look at the P/L graph for this example. The red area looks minimal at this scale, but it represents
your maximum $500 loss. The green area is your (theoretically) unlimited gain.

Slideshow Slide 2 ends here

Slideshow Slide 3 starts here

Stock Op
Strike Last Bid Ask Vol Symbol
Series Int

REC $50.00 52395

January $45 $5.50 $5.40 $5.70 125 644 REC210122C00045000

$50 $1.75 $1.50 $1.80 290 4012 REC210122C00050000

$55 $0.25 $0.20 $0.40 488 1205 REC210122C00055000

February $45 $6.00 $5.80 $6.25 55 358 REC210219C00045000

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$50 $2.50 $2.25 $2.75 125 752 REC210219C00050000

$55 $0.80 $0.50 $1.00 322 954 REC210219C00055000

March $45 $6.65 $6.50 $6.75 28 226 REC210319C00045000

$50 $3.25 $3.00 $3.50 95 620 REC210319C00050000

$55 $1.30 $1.20 $1.50 161 857 REC210319C00055000

Three Month Option Listing for Rabbit Ears Company

Example 2: Bullish
Your research tells you that REC will profit on the introduction of JackRabbit, but you aren't so
confident the price will rise 15% in two weeks. Maybe it'd be better to take a longer-term
approach. In this case the at-the-money $50 February options (REC210219C00050000) may be a
better choice. They're selling for $2.50 each now, so with your $500 you can buy only two calls.
Still, your research pointed you in the right direction, and the week before expiration the REC
stock is up to $55. These options are in-the-money and trading for $5.75 each. You sell your two
calls for $1,150 and double your original investment—another fine return.

Slideshow Slide 3 ends here

Slideshow Slide 4 starts here

Look at the P/L graph for this example. Remember, the red represents your maximum $500 loss,
and the green is your possible gain.

Slideshow Slide 4 ends here

Slideshow Slide 5 starts here

Stock Op
Strike Last Bid Ask Vol Symbol
Series Int

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REC $50.00 52395

January $45 $5.50 $5.40 $5.70 125 644 REC210122C00045000

$50 $1.75 $1.50 $1.80 290 4012 REC210122C00050000

$55 $0.25 $0.20 $0.40 488 1205 REC210122C00055000

February $45 $6.00 $5.80 $6.25 55 358 REC210219C00045000

$50 $2.50 $2.25 $2.75 125 752 REC210219C00050000

$55 $0.80 $0.50 $1.00 322 954 REC210219C00055000

March $45 $6.65 $6.50 $6.75 28 226 REC210319C00045000

$50 $3.25 $3.00 $3.50 95 620 REC210319C00050000

$55 $1.30 $1.20 $1.50 161 857 REC210319C00055000

Three Month Option Listing for Rabbit Ears Company

Example 3: Slightly Bullish

Your research tells you REC has a winner with its new JackRabbit service… but there may be some
delays in rolling out the service. Maybe it's better to be cautious. In that case, the in-the-money
$45 March options (REC210319C00045000) are probably the best bet. These are selling for $6.65
each, so you'll be able to buy only one call, albeit breaking your $500 budget by $165. But this
call already has an intrinsic value of $5, and as long as REC stock goes above $51.65 in the next
three months, you won't lose any money. In fact, REC goes up to $55 in two months, and your
one option is now worth $12. You decide to take your profits and close out your option position
for $1,200, almost doubling your original $665 investment.

Slideshow Slide 5 ends here

These are all rosy scenarios, but they're realistic. The important thing is for you to see how to use the
flexibility of options to match your hunches.

Simply Put…

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Another way of saying very bullish or slightly bullish is very risky or slightly risky. If
you're a risk-taker, you can make more profit with the cheap OTM calls, but the
expensive ITM calls are safer.

Here's another consideration: ITM calls rise more for every dollar increase of the underlying stock than
OTM options. But the point is that, with options, you can create a position to match your risk tolerance and
predictions for the underlying stock.

As before, it's a good idea to see what's happened with the P/L graph. Check this one out.

There's one last thing we want you to remember. When you place your order to buy options with your
broker, you buy to open a position. At least, that's the broker's way of putting it. Also, if you later sell your
calls, you sell to close a position. So, don't be surprised if the broker uses these terms when you place your
options orders.

You've learned a lot in this lesson! When you're ready, please head over to Chapter 5 for a recap.

In this lesson, we showed you how an option differs from and, in some ways, is similar to buying stock. We
also pointed out the strengths and weaknesses of each mode of investment. For instance, the option is a
wasting asset, but it has much more leverage than investing in stock. The option owner can't receive any
company dividends, but the stockholder can wait years for a stock price to rise. There are clearly pros and
cons to both investments, and there's certainly a time and place for both, too.

Then we looked at the distinct advantages to options, and spotlighted flexibility. The key is to make sure
you recognize the flexibility of options in general and of buying the call option in particular.

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We also talked about the circumstances under which you might consider the long call strategy. In other
words, you saw some reasons for buying calls. You saw that you had to settle on a stock that had a good
chance of appreciating soon, and we stressed that we were unable to help you with that part. But we
established the basis for using a long call strategy, and we elaborated on what steps you'd take to go
about choosing the right call option.

Hopefully the bullish examples helped you see how your level of confidence influences your option
purchase. It all comes down to how bullish you are… or, in other words, how much of a risk-taker you are
when the time comes for choosing the best call option.

Next time, we'll examine the short call option strategy. You didn't know you could sell call options you
didn't buy, did you? Let not your heart be troubled. We'll clear this up in Lesson 7. But before we do, let’s
do a quick learning check.

Learning Check

Text equivalent start.

Question Choices Feedback

If you're a risk-taker, which of a. Expensive ITM calls a. Incorrect. Expensive ITM

the following can you make
more profit with?
b. Cheap OTM calls calls are safer than cheap
c. Mixing cheap OTM calls OTM calls.
and expensive ITM calls b. Correct! You can make
more profit with cheap
OTM calls.
c. Incorrect. You can make
more profit with cheap
OTM calls.

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Question
When deciding whether to
buy a call or not, it’s best to
do what?
When deciding to buy a call,
timing is what?
Lesson 6: Buying Long Call Options
Choices Feedback
a. Only look at the a. Incorrect. While that may
fundamental analysis. be a helpful part of
b. Develop your own deciding to buy or not,
method. the best thing to do is
c. Buy only what your develop your own
friends broker advises. method.
b. Correct! Even though
there are many things
to consider, the point is,
you have to develop
your own method to
determine where or not
to buy a call.
c. Incorrect. While broker
advice (meant for you) is
a helpful part of deciding
to buy or not, the best
thing to do is develop
your own method.
a. Crucial a. Correct! Before you buy
b. Irrelevant an option, you have to
c. Not very important have some notion of
when the underlying
stock price is going up
and must act
accordingly as timing is
crucial.
b. Incorrect. Before you buy
an option, you have to
have some notion of
when the underlying
stock price is going up
and must act accordingly
as timing is crucial.
c. Incorrect. Before you buy
an option, you have to
have some notion of
when the underlying
stock price is going up
and must act accordingly
as timing is crucial.
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Question
In broker terms, when you
place your order to buy
options with your broker, you
buy to open a position. What
is it called if you later sell
your calls?
Instructions: Read the questions in the first column and consider the answer choices in the second column. Check the third
column to reveal the correct answers.
Lesson 6: Buying Long Call Options
Choices Feedback
a. Sell to profit a. Incorrect. It’s called sell
b. Closing the option to close a position.
c. Sell to close a position b. Incorrect. It’s called sell
to close a position.
c. Correct. It’s called sell
to close a position.
Text equivalent stop.
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