Anatomy of the Long Call Strategy (with a look at Greeks and Volatility)
Anatomy of the Long Call
When you are bullish on a stock or ETF, one way to express that view is by buying a call option. The long call is an aggressive option strategy, but at the same time the simplist. By owning a call option you have the right, but not the obligation, to buy that specific stock for the strike price of the option in the future. Know that every call option controls 100 shares of the underlying (stock, ETF, futures contract, etc.).
Buying a call option gives you limited risk (cost of the option), with unlimited reward.
Options have expiration dates unlike stocks. Monthly option contract’s last day of trading is on the third Friday of the month and expire on Saturday. Weekly option’s last day of trading is also on Friday, but they expire on the same day. Despite options have expiration dates, they can be bought and sold in the open market ahead of expiration.
An option can be traded from 9:30 to 4:00 EST, Monday-Friday. Stocks however, have a pre-market and after hours session that options do not.
Example of a Long Call
Exxon Mobil (trading at $91.42)
Buy to open (XOM Mar 16 ’13 $92.50 Call)
Looking at the Exxon Mobil March $92.50 call, it is currently trading for $0.90. Now say you think (XOM) will move higher over the next couple of months and you want to buy a call. You can spend $0.90 on the option ($90 because each option controls 100 shares of the stock), instead of $9142 to buy 100 shares of the stock.
If shares of Exxon Mobil move up to $95 by expiration, your call option will be worth $2.50, a gain of 178%. However, if Exxon Mobil is at $92.50 or lower by expiration, the option will be worthless. Remember that you can sell an option before expiration. So if you don’t want to take delivery of the stock with the option is in-the-money (the stock is above the strike price of $92.50), you can sell the call option for a profit (or loss) prior to expiration.
Options traders also have to know the greeks. When looking at an option analysis tool, you’ll see Delta, Gamma, Theta, Vega, and Rho. Delta and Theta are very important when you are looking at a call.
Delta tracks the move an option will make when the underlying (stock or ETF) makes a $1.00 move. Using our (XOM) call, this option has a delta of 0.4273. So if Exxon Mobil moves up $1.00, our option will gain about $0.43. When an option moves higher the delta will also rise (or fall if the stock drops). This is a second order Greek called Gamma. Gamma measures the rate of change in the Delta of the underlying.
Theta is important because of the “time dacay” factor that works against the Long Call strategy. Everyday, option values erode as time passes and the part it erodes is the extrinsic value (time value). Using Exxon Mobil example, the Theta of the (XOM) March $92.50 call is currently at -0.02. This simply means the option will lose $0.02 for everyday of the options life. So if the stock ends the day trading exactly where it did yesterday, the option should be at $0.88. If the stock moves up $1.00, the positive Delta will outway the $0.02 drop caused by Theta.
Historical Volatility (HV) and Implied Volatility (IV)
Historical volatility can be used in conjuntion with implied volatility to find out whether an option is cheap, fairly valued, or expensive. Using our (XOM) call one last time, we’ll put this into perspective.
Historical volatility is around 15%, which is relatively low in its own right. Our (XOM) March $92.50 call has an implied volatility of only 10%. As the call option is currently trading for $0.90, the theoretical value is $1.54. When buying calls or puts this is what we want, it gives us a better opportunity to profit on a trade. On the flip side, if the implied volatility were around 20%, these options wouldn’t be as an attractive trade for someone with a bullish thesis on Exxon Mobil.