Limiting risk with call options ~ How to Trade
Posted by sellacalloption
The long call option is probably one of the simplest option positions to understand. The purchaser of a call is considered to be long a call option. The long call gives the investor exposure to the upside of the market while the risk is limited to the premium paid for the option. Long calls will have a positive delta and a negative theta. LEAPS or long term equity anticipation securities can be purchased up to three years out. If you are bullish on the market for example, but concerned about global events like
sovereign debt defaults, war or terrorism you could purchase a LEAP on an index like the S&P 500, if the market rises you’ll participate. In the event an unexpected event occurs and the market takes a big hit, your risk is controlled because what you have paid for the option is much less than if you had purchased the index fund outright. Considerations to be made when purchasing a long call include the price of the underlying, the implied volatility of the option, the strike price, expiration, delta and the theta or decay factor of the option. Remember the rate of decay accelerates rapidly in the final weeks prior to expiration. Investors buying call options as a limited risk stock substitute should use longer dated contracts to give the underlying more time to make the anticipated move and to minimize the negative effects of time decay. The options delta is also a primary factor to consider. The at the money call with have a delta near 50 which means that the option will move half of what the underlying does. Out of the money calls have lower deltas as they move out of the money, they also have lower prices which equates to less capital at risk but you also need a larger price movement in the underlying to profit. The delta is roughly equal to the probability of the option being in the money at expiration, so a call with a low delta, say a 25 delta call, will only have a 25% probability of being in the money at expiration. An in the money option will have a higher delta, but will also have a higher price meaning more
capital at risk. An in the money call with a 75 delta will have a 75% chance of being in the money at expiration. If the price of the underlying rises, that call’s delta will change at a rate given by the gamma and will go to 100 if the option goes deeper into the money. Generally tactical option investors buy high delta in the money calls as a stock or ETF substitute that have a high
probability of success. When buying deep in the money calls however, it almost never makes sense to pay more for the call than you would to purchase the underlying on margin or 50% of the price of the underlying.