Why buy the right to buy the stock when you can simply buy the stock? All option strategies have trade-offs, and the long call is no different. Whether the stock or the call is preferable depends greatly on the trader’s forecast and
motivations.Consider a long call example: Buy 1 INTC June 22.50 call at 0.85.In this example, a trader is bullish on Intel (INTC). He believes Intel will rise at least 20 percent, from $22.25 per share to around $27 by June expiration, about two months from now. He is concerned, however, about downside risk and wants to limit his exposure.
Instead of buying 100 shares of Intel at $22.25—a total investment of $2,225—the trader buys 1 INTC June 22.50 call at 0.85, for a total of $85.The trader is paying 0.85 for the right to buy 100 shares of Intel at $22.50 per share. If Intel is trading below the strike price of $22.50 at expiration, the call will expire and the total premium of 0.85 will be lost.Why? The trader will not exercise the right to buy the stock at a $22.50 if he can buy it cheaper in the market. Therefore, if Intel is below $22.50 at expiration, this call will expire with no value.
However, if the stock is trading above the strike price at expiration, the call can be exercised, in which case the trader may purchase the stock below its trading price. Here, the call has value to the trader. The higher the stock, the more the call is worth. For the trade to be profitable, at expiration the stock must be trading above the trader’s break-even price. The break-even price for a long call is the strike price plus the premium paid—in this example, $23.35 per share.
The point here is that if the call is exercised, the effective purchase price of the stock upon exercise is $23.35. The stock is literally bought at the strike price, which is $22.50, but the premium of 0.85 that the trader has paid must be taken into account. Exhibit 1.1 illustrates this example.Exhibit 1.1 is an at-expiration diagram for the Intel 22.50 call. It shows the profit and loss, or P&(L), of the option if it is held until expiration. The X-axis represents the prices at which INTC could be trading at expiration.
The Y-axis represents the associated profit or loss on the position. The at-expiration diagram of any long call position will always have this same hockey-stick shape, regardless of the stock or strike. There is always a limit of loss, represented by the horizontal line, which in this case is drawn at 20.85. And there is always a line extending upward and to the right, which represents effectively a long stock position stemming from the strike.
The trade-offs between a long stock position and a long call position are shown in Exhibit 1.2. The thin dotted line represents owning 100 shares of Intel at $22.25. Profits are unlimited, but the risk is substantial—the stock can go to zero.Herein lies the trade-off. The long call has unlimited profit potential with limited risk. Whenever an option is purchased, the most that can be lost is the premium paid for the option. But the benefit of reduced risk comes at a
If the stock is above the strike at expiration, the call will always underperform the stock by the amount of the premium.Because of this trade-off, conservative traders will sometimes buy a call rather than the associated stock and sometimes buy the stock rather than the call. Buying a call can be considered more conservative when the volatility of the stock is expected to rise. Traders are willing to risk a comparatively small premium when a large price decline is feared possible.
Instead, in an interestbearing vehicle, they harbor the capital that would otherwise have been used to purchase the stock. The cost of this protection is acceptable to the trader if high-enough price advances are anticipated. In terms of percentage, much higher returns and losses are possible with the long call. If the stock is trading at $27 at expiration, as the trader in this example expected, the trader reaps a 429 percent profit on the $0.85 investment ([$27 2 23.35] / $0.85).If Intel is below the strike price at expiration, the trader loses 100 percent.
This makes call buying an excellent speculative alternative. Those willing to accept bigger risk can further increase returns by purchasing more calls. In this example, around 26 Intel calls—representing the rights on 2,600 shares—can be purchased at 85 cents for the cost of 100 shares at $22.25. This is the kind of leverage that allows for either a lower cash outlay than buying the stock—reducing risk—or the same cash outlay as buying the stock but with much greater exposure—creating risk in pursuit of higher returns.