Long Call Explained

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Short Call

What Is a Short Call?

A short call option position in which the writer does not own an equivalent position in the underlying security represented by their option contracts. Making a short call is an options trading strategy in which the trader is betting that the price of the asset on which they are placing the option is going to drop.

How Does a Short Call Work?

A short call strategy is one of two simple ways options traders can take bearish positions. It involves selling call options, or calls. Calls give the holder of the option the right to buy an underlying security at a specified price.

If the price of the underlying security falls, a short call strategy profits. If the price rises, there’s unlimited exposure during the length of time the option is viable, which is known as a naked short call. To limit losses, some traders will exercise a short call while owning the underlying security, which is known as a covered call.

Real World Example of a Short Call

Say Liquid Trading Co. decides to sell calls on shares of Humbucker Holdings to Paper Trading Co. The stock is trading near $100 a share and is in a strong uptrend. However, the Liquid group believes Humbucker is overvalued, and based on a combination of fundamental and technical reasons, they believe it eventually will fall to $50 a share. Liquid agrees to sell 100 calls at $110 a share. This gives Paper the right to purchase Humbucker shares at that specific price.

Selling the call option allows Liquid to collect a premium upfront; that is, Paper pays liquid $11,000 (100 x $110). If the stock heads lower over time, as the Liquid gang thinks it will, Liquid profits on the difference between what they received and the price of the stock. Say Humbucker stock does drop to $50. Then Liquid reaps a profit of $6,000 ($11,000 – $5,000).

Things can go awry, however, if Humbucker shares continue to climb, creating limitless risk for Liquid. For example, say the shares continue their uptrend and go to $200 within a few months. If Liquid executes a naked call, Paper can execute the option and purchase stock worth $20,000 for $11,000, resulting in a $9,000 trading loss for Liquid.

If the stock were to rise to $350 before the option expires, Paper could purchase stock worth $35,000 for the same $11,000, resulting in a $24,000 loss for Liquid.

Short Calls Versus Long Puts

As previously mentioned, a short call strategy is one of two common bearish trading strategies. The other is buying put options or puts. Put options give the holder the right to sell a security at a certain price within a specific time frame. Going long on puts, as traders say, is also a bet that prices will fall, but the strategy works differently.

Say Liquid Trading Co. still believes Humbucker stock is headed for a fall, but it opts to buy 100 $110 Humbucker puts instead. To do so, the Liquid group must put up the $11,000 ($110 x 100) in cash for the option. Liquid now has the right to force Paper, who is on the other side of the deal, to buy the stock at this price – even if Humbucker shares drop to Liquid’s projected $50 a share. If they do, Liquid has made a tidy profit – $6,000.

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In a way, it’s achieving the same goal, just through the opposite route. Of course, the long put does require that Liquid shell out funds upfront. The advantage is that unlike the short call, the most Liquid can lose is $11,000, or the total price of the option.

Long Position vs. Short Position: What’s the Difference?

Long Position vs. Short Position: What’s the Difference?

When speaking of stocks and options, analysts and market makers often refer to an investor having long positions or short positions. While long and short in financial matters can refer to several things, in this context, rather than a reference to length, long positions and short positions are a reference to what an investor owns and stocks an investor needs to own.

Understanding a Long Position vs. a Short Position

Long Position

If an investor has long positions, it means that the investor has bought and owns those shares of stocks. By contrast, if the investor has short positions, it means that the investor owes those stocks to someone, but does not actually own them yet.

For instance, an investor who owns 100 shares of Tesla (TSLA) stock in his portfolio is said to be long 100 shares. This investor has paid in full the cost of owning the shares.

Key Takeaways

  • With stocks, a long position means an investor has bought and owns shares of stock.
  • On the flip side of the same equation, an investor with a short position owes stock to another person but has not actually bought them yet.
  • With options, buying or holding a call or put option is a long position; the investor owns the right to buy or sell to the writing investor at a certain price.
  • Conversely, selling or writing a call or put option is a short position; the writer must sell to or buy from the long position holder or buyer of the option.

Short Position

Continuing the example, an investor who has sold 100 shares of TSLA without yet owning those shares is said to be short 100 shares. The short investor owes 100 shares at settlement and must fulfill the obligation by purchasing the shares in the market to deliver.

Oftentimes, the short investor borrows the shares from a brokerage firm in a margin account to make the delivery. Then, with hopes the stock price will fall, the investor buys the shares at a lower price to pay back the dealer who loaned them. If the price doesn’t fall and keeps going up, the short seller may be subject to a margin call from his broker.

A margin call occurs when an investor’s account value falls below the broker’s required minimum value. The call is for the investor to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin.

Key Differences

When an investor uses options contracts in an account, long and short positions have slightly different meanings. Buying or holding a call or put option is a long position because the investor owns the right to buy or sell the security to the writing investor at a specified price.

Selling or writing a call or put option is just the opposite and is a short position because the writer is obligated to sell the shares to or buy the shares from the long position holder, or buyer of the option.

For example, an individual buys (goes long) one Tesla (TSLA) call option from a call writer for $28.70 (the writer is short the call). The strike price on the option is $275 if TSLA trades for $303.70 on the market.

The writer gets to keep the premium payment of $28.70 but is obligated to sell TSLA at $275 if the buyer decides to exercise the contract at any time before it expires. The call buyer who is long has the right to buy the shares at $275 at expiration from the writer if the market value of TSLA is greater than $275 + $28.70 = $303.70.

Long Call

The Strategy

A long call gives you the right to buy the underlying stock at strike price A.

Calls may be used as an alternative to buying stock outright. You can profit if the stock rises, without taking on all of the downside risk that would result from owning the stock. It is also possible to gain leverage over a greater number of shares than you could afford to buy outright because calls are always less expensive than the stock itself.

But be careful, especially with short-term out-of-the-money calls. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment, whereas if you own the stock it will usually still be worth something. (Except for certain banking stocks that shall remain nameless.)

Options Guy’s Tips

Don’t go overboard with the leverage you can get when buying calls. A general rule of thumb is this: If you’re used to buying 100 shares of stock per trade, buy one option contract (1 contract = 100 shares). If you’re comfortable buying 200 shares, buy two option contracts, and so on.

If you do purchase a call, you may wish to consider buying the contract in-the-money, since it’s likely to have a larger delta (that is, changes in the option’s value will correspond more closely with any change in the stock price). You can learn more about delta in Meet the Greeks. Try looking for a delta of .80 or greater if possible. In-the-money options are more expensive because they have intrinsic value, but you get what you pay for.

The Setup

  • Buy a call, strike price A
  • Generally, the stock price will be at or above strike A

Who Should Run It

Veterans and higher

NOTE: Many rookies begin trading options by purchasing out-of-the-money short-term calls. That’s because they tend to be cheap, and you can buy a lot of them. However, they’re probably not the best way to get your feet wet. The Rookie’s Corner suggests other plays more suited to beginning options traders.

When to Run It

You’re bullish as a matador.

Break-even at Expiration

Strike A plus the cost of the call.

The Sweet Spot

The stock goes through the roof.

Maximum Potential Profit

There’s a theoretically unlimited profit potential, if the stock goes to infinity. (Please note: We’ve never seen a stock go to infinity. Sorry.)

Maximum Potential Loss

Risk is limited to the premium paid for the call option.

Ally Invest Margin Requirement

After the trade is paid for, no additional margin is required.

As Time Goes By

For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.

Implied Volatility

After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction (but you’ll hope the direction is up).

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.
  • Remember: if out-of-the-money options are cheap, they’re usually cheap for a reason. Use the Probability Calculator to help you form an opinion on your option’s chances of expiring in-the-money.
  • Use the Technical Analysis Tool to look for bullish indicators.

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