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Comparing Contracts in a Long Call Strategy

Comparing Contracts in a Long Call Strategy

Key Points
  • Using long call options to speculate on a stock’s potential upside can be more complicated than you think.

  • When initiating a speculative long call options strategy, it’s important to understand the trade-offs associated with the various strikes and expirations.

  • We look at how the Theoretical View in StreetSmart Edge® can help you understand potential outcomes. 

A common way for bullish option traders to get upside exposure is by purchasing calls, which give you the right to buy the stock at the strike price at any time until the expiration date. This long call option strategy is popular because it offers a relatively low-cost way to get exposure to a stock, and it can also be used for leverage. While these features may be appealing, this strategy doesn’t come without its risks as investors can lose 100 percent of the principal invested.

Indeed, using long calls to speculate on the potential upside of a stock can be more complicated than you think. The risk/reward characteristics of each call can vary greatly depending on the strike price and expiration date selected. Here, we'll explore some of these differences and consider scenarios in which your forecast doesn't turn out as expected.

The set-up

First, let's look at what to consider as you set up your long call strategy. Here's a hypothetical example:

  • Let's assume it's January 5, 2014 and you've identified a stock (XYZ) that you believe will move higher over the near term. 
  • You've decide to purchase some calls in order to capitalize on this potential outcome. 
  • You want to invest $2,500 on this particular trade and you are in the process of deciding which strike prices and expiration dates you prefer.

You look for around-the-money calls for the next three expiration dates and you see the following options contracts in the XYZ option chain:

the set up

Source: StreetSmart Edge®. 

Keep in mind, the more contracts you purchase the more leverage you obtain. This is generally what draws speculators to the relatively lower-priced options (i.e., contracts trading below $1.00). Generally, the farther out-of- the-money an option is, and the closer it is to expiration, the lower its price. While these lower-priced options typically provide the highest return if the underlying price makes a significant (favorable) move in a short period of time, there are significant trade-offs.

To illustrate, I'll compare a relatively aggressive, low-priced contract to a contract that I consider more conservative. Note that the terms "aggressive" and "conservative" apply to a long call strategy used for speculation (versus one used as a "stock replacement" ). When you use options strategies as a substitute for stock ownership, be aware that with options you forgo dividends and voting rights, and options eventually expire.

In this example, "XYZ" represents an actual stock and its associated data, so we can look at a real-world contract comparison. However, option pricing varies among individual securities and among the available contracts on a given security, so every option contract has a unique blend of risk and reward.

Contract comparison

Table 1 compares a relatively aggressive XYZ January 32.00 call and a relatively conservative XYZ March 30.00 call.

Table 1: Aggressive vs. conservative call comparison

XYZ Price = $31.51

Contract Cost/Contract Number of contracts Cost Delta Theta Days until expiration Break-even price (at expiration)
January 32.00 Call 0.52 48 $2,496 0.34 -0.0320 13 32.52
March 30.00 Call 2.41 10 $2,410 0.61 –0.0116 76 32.41

Source: Schwab Center for Financial Research.

What do these parameters mean?

  • Cost per contract. Because of their lower cost per contract, you can purchase 48 January 32.00 contracts versus only 10 March 30.00 contracts. So the January 32.00 call position represents 4,800 shares of XYZ, while the March 30.00 call represents only 1,000. 
  • Delta. Measures how much an option's price is expected to move with a corresponding $1.00 movement in the price of the underlying security. Looking at Delta in this manner, we can see that the March 30.00 call should initially move more than the January 32.00 call on a dollar/dollar basis, but not on a percentage basis (more on this later).

Delta also represents the approximate probability that a contract will close in the money by expiration. The March 30.00 call has a 0.61 Delta, which indicates that there's a 61% chance of being in the money by the March expiration. The January 32.00 call, on the other hand, has a 0.34 Delta, indicating there's a 34% chance of being in the money by the January expiration. 

  • Theta. One of the biggest enemies for long option traders is time decay. Assuming the price remains unchanged and all other variables are held constant, the Theta on the 32.00 strike implies that this contract will initially lose approximately 3.20 cents (or 6.15%) a day, versus 1.16 cents (or 0.48%) a day for the 30.00 strike. The significantly higher Theta on the 32.00 call is primarily due to the fact that the contract is composed entirely of time value and it is only 13 days away from expiration.
  • Break-even. While the break-even price points of both calls are similar, the January 32.00 call allows only 13 days for XYZ to rise 3.2% (from 31.51 to 32.52) while the March 30.00 call provides 76 days to rise 2.9% to its breakeven price.

What might happen?

As traders, our job is to use as many indicators and historical data points as possible to develop a forecast. Regardless of our conviction level with any given forecast, it's impossible to be 100% sure what will happen in the future. Setting our biases aside and taking an objective view about the possible XYZ outcomes may assist us in the decision-making process. Visualizing possible XYZ outcomes as a distribution curve might look something like this:

what might happen

Source: StreetSmart Edge® and Schwab Center for Financial Research. 

What are the potential outcomes?

Consistently making money speculating with long options is difficult, and you'll want to gather as much information as possible before making a decision. Ask yourself what would happen if:

  • The price of XYZ moves higher but not as fast as you anticipated. 
  • XYZ trades sideways or, worse, its price declines. 
  • Your forecast is wrong.

The Theoretical View within the option chains on the StreetSmart Edge® trading platform can help you answer these questions by helping you estimate how option prices will be affected by time and direction.

Table 2: XYZ moves higher*

  Theoretical price of XYZ 01/18/2014 32.00 C Theoretical price of XYZ 03/22/2014 30.00 C
XYZ + $2.00 immediately 1.54 (+196%) 3.77 (+56%)
XYZ + $1.00 immediately 0.94 (+81%) 3.04 (+26%)
XYZ + $0.50 immediately 0.71 (+37%) 2.71 (+12%)
XYZ + $1.00 in 3 days 0.83 (+60%) 3.01 (+25%)
XYZ + $0.50 in 3 days 0.59 (+13%) 2.67 (+11%)
XYZ + $1.00 in 7 days 0.65 (+25%) 2.97 (+23%)
XYZ + $0.50 in 7 days 0.42 (-19%) 2.63 (+9%)

Source: Schwab Center for Financial Research.

Table 2 illustrates the benefit of using leverage when the stock moves in your favor. In the top three "immediate" scenarios, the 32.00 call significantly outperforms the 30.00 contract. As the move higher takes longer to occur, the performance discrepancy begins to narrow, and the final scenario conveys the importance of timing, as the 32.00 contract significantly underperforms the 30.00 call.

Table 3: XYZ stays flat*

  Theoretical price of XYZ 01/18/2014 32.00 C Theoretical price of XYZ 03/22/2014 30.00 C
XYZ stays flat in 3 days 0.41 (–21%) 2.36 (–2%)
XYZ stays flat in 7 days 0.25 (–52%) 2.31 (–4%)
XYZ stays flat in 13 days 0.00 (–100%) 2.23 (–7%)

Source: Schwab Center for Financial Research.

Generally speaking, if the underlying stock remains flat over a period of time, the primary factor affecting the price of the corresponding option is time decay. This is especially true for out-of-the-money options with nearer expiration dates. For example, the 32.00 call is out of the money and its initial 0.52 price is composed entirely of time value so it has a relatively high Theta of –0.032. This means that if the price of XYZ remains unchanged, the contract is estimated to initially lose 3.2 cents or 6.15% of its value per day. Compare this to the 30.00 call whose $2.41 price has 0.90 of time value ($2.41– $1.51 intrinsic value) but a considerably lower Theta of –0.0116.

Table 4: XYZ moves lower*

  Theoretical price of XYZ 01/18/2014 32.00 C Theoretical price of XYZ 03/22/2014 30.00 C
XYZ –0.50 immediately 0.36 (–31%) 2.10 (–13%)
XYZ –0.50 in 3 days 0.27 (–48%) 2.06 (–15%)
XYZ –0.50 in 7 days 0.14 (–73%) 2.01 (–17%)
XYZ –1.00 immediately 0.24 (–54%) 1.82 (–24%)
XYZ –1.00 in 3 days 0.17 (–67%) 1.78 (–26%)
XYZ –1.00 in 7 days 0.07 (–87%) 1.74 (–28%)

Source: Schwab Center for Financial Research.

Table 4 shows that if our bullish forecast is completely wrong, both contracts suffer but the 32.00 call is in much worse shape. The declines in the 30.00 call are still significant, but its more distant expiration date allows more time for the underlying price to potentially recover.

What to remember

When a stock price increases both sharply and quickly, out-of-the-money options with closer expiration dates will typically outperform (on a % basis) in-the-money options with more distant expiration dates. In the event that your forecast is wrong, however, an in-the-money contract with a more distant expiration date will provide a bigger price buffer.

It's impossible to know which contract will have the highest return because we don't know what will happen to the price of the stock in the future. However, we can analyze potential outcomes using the Theoretical View in StreetSmart Edge to determine the risk/reward characteristics of a given contract and select the one that suits your individual preferences.

*A note regarding the data presented in tables 2, 3 and 4: Theoretical returns depict probable changes based on magnitude and timing changes only, and do not take into account other possible changes to pricing model inputs. Data shown are for illustrative purposes only, and should not be construed as indicative of any actual scenarios.

Next Steps

  • Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
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