Long Calls

A call option is the right, not the obligation, to buy a stock at a specific price on or before a specific date.  Ok let’s get past this boring definition and answer the real question how does a call make you money? 

A call is really a simple way of taking advantage of an upward price move in the stock.  Most traders like this strategy to begin with because it is simple and with the right move it can generate a good amount of ROI if the trade is successful.

One of the advantages of buying options like a long call is the fact that risk is limited and the reward can be large.  Below is a risk graph that shows if you buy an option contract for 2.00 or ($200 per contract)  I cannot lose more than that amount.  If it rises above $42 before its expiration date you would essentially have an unlimited amount you could earn on that option.

 

 Another factor that is not shown here is that if the stock moves up dramatically before its expiration the risk graph will curve and that means that your options can be more valuable sooner.

In The Money Calls (ITM) vs Out of the Money Calls (OTM)

This is a question a get asked a lot which is better?  There is really no good answer other than it really depends.  What you have to understand is that OTM calls are typically more expensive and will move more in step with the stock and are less likely to expire worthless.  You would typically buy an ITM call if the price movement is steady over time or that you want more certainty that the trade will be ITM by the end of your trade.

On the other hand OTM calls are less expensive and have a more likely hood of expiring worthless, but have a higher ROI if the stock that is out of the money goes ITM before expiration.

When Should You Buy A Call?

When you see that the stock is going to go up.  You can look to technical analysis to the answer that question.  Two common patterns that will help determining whether you buy a call or not is support (a price floor) of break out (breakout above a price ceiling)

Support

Support is key to understanding if the price is going to move up. In the example below Goldman Sachs (GS) found support after it hit a low of $90 and then made a second equal low in late June.   Each bounce was a little higher than the previous indicating that this stock was creating a trend.

 

 

Breakouts

Another situation on a chart that might present itself is a stock break out. Apple had a breakout about a year ago.  After it had been trading in a range for the good part of the 2011.  It broke above its $350 price ceiling and has not stopped climbing since.

 

So in summary a call option is a way to speculate, predict, and take advantage of a upward price move in the underlying security.

If you would like help in understanding how to trade options please feel free to inquire about our education program at CMT Trader.com or send an email to cmttrader@live.com for information.