Call

bullOcall
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spread DEFINITION

A Call Option is a contract that gives the buyer the right, but not the obligation, to buy a stock
at a specific price (strike price), on or before a specific date (expiration date). Whereas stocks
are traded in shares, call options are traded in contracts. Usually one contract controls or
represents 100 shares of stock. Buying a call option is a limited risk, unlimited reward trading
strategy which profits if the underlying stock rises in price. It offers a cheaper, more leveraged
way to place a bullish bet on a stock.

S T R AT E G Y

The maximum loss for a long call option is limited to the debit paid to purchase the call
option. The maximum loss is realized if the stock price resides below the strike price of the
call option at expiration.

MA X LO SS = DEBIT PA ID

Max Loss Occurs If the Stock Price is Below the Strike Price at Expiration

The maximum gain for the long call option is theoretically unlimited. The call option owner
continues to make money as the stock rises in price up until when the call option expires.

MA X GA IN = UNLIMIT ED

The break-even point for the long call option can be calculated using the following formula:

B R EAK EVEN PO INT = ST RIKE PRICE + DEBIT PA ID

This is referred to as the expiration breakeven. As long as the stock price is above this price
at expiration you will capture some type of profit.

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EXAMPLE
Suppose stock XYZ is trading at $46 in December and you believe it will rise in price over
the coming months. Instead of buying 100 shares of stock, you could take the cheaper, more
leveraged route and buy a call option. Let’s assume you buy the April 45 call option for
$400. The $400 debit you paid represents your maximum loss and will be incurred if XYZ is
below $45 at April expiration. As previously mentioned, your maximum gain will be unlimited
up until April expiration. Suppose XYZ is trading at $70 on April expiration. How much profit
would you have? Though the stock is currently trading at $70, you have the right to buy 100
shares at $45. Consequently, your call option would be worth $2500. If we subtract the
initial cost of the trade from $2500 (2500- 400), we arrive at a profit of $2100. That’s a
whopping 525% return.
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QUICK TIP
In deciding which call option to buy, traders must choose from various expiration months and
strike prices. Most stocks offer at least five different expiration months to choose from: the
front two months, the next two quarters, and LEAPS. Suppose it is December 1st, 2009 and
you are assessing the options chain for XYZ options. You would probably see the following
expiration months available: December, January, April, July, January 2011, January 2012.
In terms of which month to buy, it is often recommended to buy twice as much as you think you
need. For example, if you anticipate being in the trade for two months, then buy a four month
option.
In each expiration month there are various strike prices to choose from. Call options with a
strike price below the current stock price are referred to as in-the-money. Those with strikes
above the current stock price are referred to as out-of-the money. Buying in-the-money call
options is generally more conservative and requires the stock to move less for you to profit.
Buying out-of-the money call options is considered more speculative and requires the stock to
move more for you to profit. Consequently, it is usually recommended to buy in-the-money op-
tions. As you become more experienced with buying call options, you may eventually dabble
with trading out-of-the money options.
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bull call
An alternate strategy to buying call options that also exploits a bullish move in a stock is the
married put. A married put consists of buying 100 shares of stock and simultaneously buying
a put option. In fact, the risk-reward of both strategies is virtually identical and they are often
referred to as synthetic equivalents.

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