Debit/Debit Spread Strategy:
Long Call

AKA: Call, Buying Call Options

ANALOGY/METAPHOR: Playing the Slot Machines at a Casino

ACTION: Buy 1 in the money (ITM), at the money (ATM), or out of the money (OTM)call option. And then hope like hell the stock immediately starts moving higher. That's essentially all there is to this strategy.

The Long Call is a wasting asset. It consists of intrinsic value if it's in the money plus time value. As time passes, the option will lose value through time decay, until eventually all time value is wrung from it. Strong moves to the upside, however, will more than make up for the loss of time value. A long call on a stock that moves significantly higher is a powerful leverage that can result in astounding double, triple, and sometimes quadruple digit gains.

DESCRIPTION: As a reminder, what you're literally doing by purchasing a long call option is paying for the right to purchase 100 shares of stock at a certain price by a certain date. You do so because you believe that the stock will be higher by the time the option expires, and that the price you're locking in represents a significant discount to that future price. By purchasing a call option instead of 100 shares of actual stock, you only put up a fraction of the capital. Therefore your profits, and losses, will be magnified as you calculate your returns based on the investment cost of the options rather than the investment cost of 100 shares of the underlying stock.

In practicality, using a long call option by itself is a bet against the house in the hopes of hitting a jackpot. It's an aggressive bet on the near term upward move of a stock. If the stock remains flat, the value of the option steadily bleeds away. If the stock drops, the effect is more like that of a severed artery. The value of the option hemmorages and you can quickly see large, double digit losses. If you hold on to the option until expiration, and the stock closes below the strike price, you will lose every penny of your original investment.

But if the stock does what you hoped it would--move sharply higher--there's no more effective way to maximize huge returns than with a long call. The strategy may also be likened to being a quarterback who's blitzed on third down. Oh--you're also playing against a team who's allowed about five extra players. The most likely outcome is that you're going to get knocked on your ass.

If, however, you're fortunate and you're able to get the pass off in time, there's a wide open receiver in the backfield with nothing between him and the end zone.

EXAMPLE: The XYZ Zipper Company has been trending higher recently and is now trading at $38/share. You believe that the company's fundamentals and technicals are both sound and that the upward trend will continue. You purchase a $40 call option expiring in one month for $1 (i.e. a $100 debit). This is an OTM call and consists solely of time value. If the stock closes anywhere at $40 or below, the option will expire worthless.

But let's suppose you were right about the stock. Positive news is released--velcro sales are way down, which bodes well for the zipper industry--and XYZ stock continues climbing higher. On Expiration Friday, the stock is trading @ $42/share. Your $1 call option is now worth $2 per contract ($42/share minus $40 strike price at which you're eligible to purchase the stock).

If you would've bought 100 shares of stock in lieu of the call option, you would've made $400 and about a 10.5% return ($400 divided by the $3800 original investment). But you also would've been exposed to downside risk in the stock. Theoretically, if something really terrible had happened and the stock traded down to zero, you would've lost up to $3800.

But with the call option, the most you could've lost was $100. And your ultimate return of $100 represents a 100% return on your invested capital.

VARIATIONS: Simply buying a long call option is an inherrently risky strategy since the stock HAS TO make a strong move upward, and in a certain time period, for you to make money. It's also risky in that it's next to impossible to break even. You can almost bank on the assumption that you're going to get double digit returns. The only question is whether those returns will be negative or positive.

But like all option trading strategies, even a simple long call strategy can be made more or less risky. You can reduce risk by adjusting these factors:

1. The Strike Price - The deeper in the money (DITM) the strike price is, the more the call option is comprised of intrinsic value rather than time value. And it's time value that kills the buyer of options. Intrinsic value means there's something of real value there, something that will remain on Expiration Friday even if the stock doesn't get to where you wanted it to go. Obviously then, an ITM Call Option will require more capital upfront than its OTM counterpart, and on a percentage basis, the potential returns will be much less. But with an ITM option (and especially a DITM option), your risk of losing your entire investment is diminished.
2. The Expiration Date - In the same way, the farther out in time the expiration date is, the more time you allow the stock to move higher. The downside, of course, that the farther out in time the expiration date is, the more you'll have to pay for the option. That again equates to a larger capital investment and therefore a reduction, on a percentage basis, of your potential returns.

OTHER:

A couple of items:

First, I want to address a double standard or false logic that is routinely promoted in the advocation of buying call options (and other strategies as well). It's the double standard of hyping both the limitied capital risk aspect of the trade as well as the potentially huge percentage gains aspect. In short, you can't have it both ways. After a successful trade, you can't go around saying, "I just made a 100% gain in twelve days! And I only risked $500!" A 100% return on $500 is still only $500. That equates to a 10% return on a $5,000 dollar investment and a 1% return on a $50,000 investment. If you wanted a potential 100% return on your entire portfolio, then you'd have to put the entire thing at risk. It is possible to make money buying options. Many salmon make it all the way back upstream to spawn, which is very inspiring and speaks to the power of instinct and will. But don't forget the other lesson--most salmon don't make it.

Second, the long call and the long put option trading strategies are such similar strategies (practically, the only difference is the direction the trader hopes the underlying stock will move) that much of the descriptions and wording of each strategy will be redundant and even identical. It's no crime to plagiarize oneself. Plus it's difficult coming up with entirely new scenarios and misadventures for The XYZ Zipper Company.


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