The Long call has maintained its popularity among traders since its introduction in 1973.  The call option provides the foundation for many advanced strategies.  Therefore a thorough understanding of the fundamentals is necessary.

Application

The investor is confident that the underlying stock is going to make a bullish move.  By using a call option the holder is able to significantly leverage his or her money by paying a premium far less than the price of the share itself.  The primary motivation of this investor is to realize financial reward from an increase in price of the underlying security.  The key is to select the proper option (expiration and strike price) that will produce the most profitable return.  Generally, the more out-of-the-money the call is, the more bullish the strategy.  In this case, the underlying must make a significant move for the position to break-even.

As Previously mentioned, the investor who purchases a call instead of the actual stock, is considering the reduced cost of purchasing the call versus the equivalent shares in the stock.  One call contract controls 100 shares of the underlying equity.  The uncommitted capital may then be invested elsewhere. While holding the call option, the investor has the right to purchase the equivalent number of shares at  the pre-determined strike- price any time prior to the options expiration.  Equity option holders do not enjoy the right to vote or receive dividends, unlike the investor that holds shares in the underlying.

Benefit

Because of the increased leverage, and lower up-front commitment, a long call option may offer a significantly better return on investment over stock ownership.  An option holder also has a pre-determined risk, no greater than the premium paid.

Risk vs. Reward

Maximum Profit: Unlimited

Maximum Loss: Limited to Net Premium Paid

Upside Profit at Expiration:
Stock Price - Strike Price - Premium Paid
Assuming Stock Price above Break Even Point

The maximum profit of the position depends on the potential for a price increase in the underlying.  An in the money call will generally be worth its intrinsic value at expiration.  The loss, although pre-determined, can be 100% of the premium if the position is not managed properly.  An out-of-the-money call is worth zero upon expiration.

Volatility

The Implied volatility of an option is a measure of the amount by which the underlying security is expected to fluctuate over a period of time.  It reflects the markets expectations and can change at any time based on news or other events affecting the stock.

Volatility Increases:  Positive Effect
Volatility Decreases: Negative Effect

Any effect of volatility on the option's total premium is on the time value portion.

Passage of Time: Negative Effect

An options time value portion will decrease as an option moves closer to expiration. The rate of time decay increases considerably with the last month before expiration.  It is important to give yourself sufficient time for a move in the underlying to take place.  

To determine the time value portion of an options premium:

Premium - Intrinsic value = Time Value

An option holder can sell the call in the options market to close out the position.  This may be done in order to realize a profit or to cut losses on a losing trade.  

The presence of  Market Makers on each of the 6 option exchanges insures liquidity in the absence of public orders.

Upon Expiration?

Because equity options are standardized derivatives, they expire on the third Friday of the expiration month.  If the option has any intrinsic value or, in other words, the option is in-the-money, the holder may elect to sell the contracts for a profit before the end of the trading day.  As an alternative, the holder may wish to exercise thereby purchasing the equivalent shares at the strike price.  

If the option is out-of-the-money, it will expire worthless.

An Example

If the investor feels that a certain stock is about to make a bullish move, he or she may either purchase the stock outright, or purchase "the right to purchase the stock", or a call option.  Holding a call offers the benefits of owning a stock (except for dividends and voting rights), yet requires less capital than actually purchasing the stock.  Unlike out right stock ownership, the call option has limited terms and an expiration date.

Say for example Symantec Corporation (SYMC) is trading at $19.95,  it would require $19,950 to buy 1000 shares of the stock. Instead of buying the stock the bullish investor could purchase a  SYMC "call option" with a strike price of $20.00 and an expiration date 3 months out.  For instance, in January the investor could Buy 10 SYMC April $20.00 Calls for $1.20. This will allow the investor to participate in the upside movement of the stock while minimizing the downside risk.

Since each contract controls 100 shares, the investor would buy the right to purchase 1000 shares of SYMC for $20.00 per share. The price or premium, $1.20, is quoted per share. Consequently, the cost of this position is $1200.00 ($1.20 x 100 shares x 10 contracts).

If the stock stays at or below $20.00 before the options expire, The most the option holder could lose is $1200.00.  On the other hand, if the stock rises to $25.00, the options will be worth at least $5.00 upon expiration (current price: $25.00 - strike price: $20.00). The investor must keep in mind that if this move takes place before expiration, the option will be worth the intrinsic value ($5.00) plus any time value remaining.  Therefore, in this example the $1200.00 investment would be worth at least $5000.00 ($5.00 x 100 shares x 10 contracts).  

If the investor bought 1000 shares of stock at $19.95, he or she would be putting $19,950.00 at risk. If the shares were sold when the price rose to $25.00, the shareholder would make $4950.00 on the initial $19950.00 investment, a 25% return. In comparison, investing $1200.00 in call options only puts $1200 at risk. In this case, the return is 66%.

If the stock drops in price:

This scenario appears intimidating on a percentage basis, however, it is clear that if the stock drops, the investors loss is limited to the initial investment, in this case $1200.00. In contrast, the stockholder sustains a far larger dollar loss of $4950.00 By comparing the limited downside and the unlimited upside potential of the call options, it is evident as to why they are such an attractive investment for bullish investors.