Upbeat music plays throughout.
Narrator: Long calls can be some of the riskiest options trades you can make. If you're right about the timing and size of a stock's move, buying calls can deliver big profits without even owning the stock. But if you're wrong about price, time, or volatility, you can lose some or all of your investment really quickly. But not all long call strategies are equal.
Some people swing for the fences every time, making fast pie-in-the-sky bets with high risk and high potential returns. That can mean big wins when it works out, but it's also a strategy that could bring lots of strikeouts and big losses.
A different approach is more about pursuing success through lots of singles and doubles over time—trades that last for a few days to a few weeks but may move at a more manageable pace.
I'm Education Coach Cameron May, and I've been teaching new traders about options for 15 years. I've seen a lot of the mistakes traders make, so I'm gonna teach you about ways to avoid those mistakes.
On-screen text: How long calls work, A smarter way to trade, How to trade long calls on thinkorswim®
Narrator: We'll talk through how long calls work and discuss a smarter way to trade them that might offer lower profits per trade but may increase the likelihood of success over time.
I'll also show you how to set up and manage this strategy on thinkorswim®.
For this video, we'll assume you have a basic knowledge of options, the options greeks, and the thinkorswim platform, so if you're an absolute beginner, check out our other videos on getting started with options.
On-screen text: Long call buyer has the right to buy 100 shares at the strike price before expiration.
Narrator: So, what is a long call? A long call is a bullish speculative trade where you buy a call option on an underlying security you expect to move up, ideally in a big way and quickly. Buying a standard call option contract gives you the right to buy 100 shares of stock at the strike price on or before its expiration day, though getting stock isn't the goal of this strategy.
You expect the long call's value to increase when the stock price goes up so you can sell back the contract for a profit before expiration. But the move has to be big enough and quick enough to make up for the effects of time decay, which erodes the contract's value.
Animation: A chart simulating the action of a stock price appears on screen. The price line turns to a dotted line.
On-screen text: Option, Strike Price $81. Premium $3 multiplied by 100 equals $300.
Narrator: For example, let's say XYZ stock is currently trading at $81 per share, and you think it'll go up in the next few days. You buy an at-the-money call contract with an $81 strike price for a premium of $3 or a total of $300, with the expectation that the premium will increase sufficiently over the next few days for you to sell the option for a profit. But how much does the stock need to go up? And what if it doesn't?
Animation: A graph with Stock price on the x-axis and Profit and Loss on the y-axis shows a horizontal line halfway through the graph and then it turns higher. The line ends with an arrow and label of Max gain, Unlimited.
Narrator: Let's take a look at the long call's risk profile. The maximum gain for a long call strategy is unlimited because the underlying stock could skyrocket, boosting the premium in the process. And keep in mind, options profits aren't linear. The higher the stocks goes, the faster your potential profits can accumulate.
On-screen text: Disclosure: Please Note: Carrying a long call into expiration can entail additional risk of loss beyond the premium paid. If the option expires in the money, it could be exercised for you. If you did not set aside the cash to buy the stocks, an unexpected exercise could require urgent action to come up with the cash for the settlement.
Narrator: This is one reason long calls are so appealing to traders. The maximum loss is limited to the premium you've paid. You could lose 100% of your investment in the option if the underlying turns bearish or even just goes sideways.
The break-even point for a long call at expiration is the strike price plus the premium paid. However, we don't plan to hold this option until expiration, so there are three forces that can determine the profitability of the trade in the meantime: price, time, and volatility. These forces are measured by the options greeks.
Animation: An option contract's premium is $4 and has a delta of 0.50. A stock chart shows the price moving up by $1 and the premium changes from $4 to $4.50.
Narrator: The first force is price and is measured by delta. Long calls are delta positive, which means call prices rise along with the stock price. This greek will give you a sense of how much the options contract price may change with a $1 move in the price of the underlying.
The next force is time. Theta measures the impact of time decay on the long calls—it's negative, so it works against our position. The closer you get to expiration, the harder theta works against you. An expiration that's further away helps alleviate some of that risk by reducing the rate of time decay.
Our goal is to plan for a profitable exit before theta melts away too much premium.
The last force is volatility. Vega tells us how rising or falling implied volatility could impact our options trade. Long calls have positive vega so, ideally, we'd like to see volatility rise. But remember, implied volatility often moves opposite of the stock's price movement, so it's pretty common to see volatility drop if the stock price moves up.
On-screen text: An option contract with three dollar signs above it moves along a timeline toward an illustration of a phone. Once the contract moves past the phone, two of dollar signs disappear.
Narrator: So volatility is often another force working against a long call. Now that we've covered how long calls work, let's get into some common mistakes people make when trading them. The first is buying calls before a big event like earnings in hopes of profiting from big moves.
Animation: Long call buyer has the right to buy 100 shares at the strike price before expiration. The images change to a graph labeled Volatility crush. The graph of the options premium moves higher until it reaches a phone icon, then it falls dramatically.
Narrator: The problem is that the options can be expensive at this time because of the high implied volatility. But as soon as the event occurs and the uncertainty around price movement ends, all that extrinsic value disappears and the price of the options collapse. This is called a volatility crush, and it can be so dramatic that even if the stock moves in your direction, you can still lose money.
On-screen text: Disclosure: Past performance of a security or strategy is no guarantee of future results or investment success.
Narrator: Take Tesla for example. I'm going to use a thinkorswim tool called thinkBack™ to look at historical data. Here we are on October 21, 2020, the day Tesla (TSLA) announced earnings after the closing bell. The closing stock price before the announcement was $422.64. By the end of the next day, it was up just over $3 at $425.79. With the leverage offered by long calls, you might typically expect a profit as a result of a one day move of that size.
But let's see what actually happened with the options. On October 21, the October 30 at-the-money 422.50 call closed at $24. The next day, despite the rise in Tesla's price, the same call closed at only $15.80, suffering about a 34% drop in value. Some of this drop can be attributed to time decay, but the real culprit was the volatility. You can see why it's called a volatility crush.
The stock would've needed to rise an extra $14 to overcome that crush. Up next is what I call the lottery ticket. By that I mean buying way out-of-the-money strikes because they're cheap, and the potential return is huge. These contracts are cheap for a reason. Far out-of-the-money contracts often expire worthless because the probability of the stock moving enough to make them profitable is very low.
I've got the December 11 call options for Chipotle Mexican Grill, ticker CMG, pulled up. It's currently trading around $1,323. Toward the bottom of the option chain is the 1410-strike, which is almost $90 out of the money. You could buy a contract for just $400 bucks on the off chance it'll make a big move, but check out the bid/ask spread. It's $1.35 on a $4 contract.
These way out-of-the-money options tend to be thinly traded and poorly priced in a way that puts you at a disadvantage. The stock would have to make a significant move up just to overcome that obstacle. Plus, if you've based this lotto ticket around an earnings event, the volatility crush could impact your losses too.
Another common mistake is choosing an expiration that's way too soon, like next week. Some investors do this because the options are often cheaper, but if it doesn't make a big move quickly, time decay kicks into high gear. The closer you get to expiration, the faster time decay erodes your position. Let's take a look at an example of the impact of time decay.
A great tool to do this is called theoretical price, or theo price, which I'll pull up. The theo price allows you to experiment with changes in price, time, and volatility. To begin our experiment, here's the 126 call on Apple expiring next week. The theo price begins with the current mid-price of that option, which is currently $1.32.
Now, using the theo price menu, I'll simulate just one day passing and look at what happens to the simulated value of the option even if the stock price stays the same. It fell around 10% over night.
And as I mentioned, it'll only get worse the closer you get to expiration. The last big mistake some traders make is trading without an exit strategy. Before you ever enter the trade, it's important to give yourself a point where you're ready to cut and run.
On the upside, that point could be something as simple as a specific price target of the underlying stock or a specific gain on the option. On the downside, that could mean using stop orders or exiting if you haven't hit your price target by a certain date. If you don't stick to your exit rules, you could make gains and watch them slip away while hoping for more gains.
On-screen text: A "smarter" approach to long calls. ATM options, A few months from expiration, Uptrending stocks could make big moves.
Narrator: Now that you know what not to do, let's look at a smarter approach to trading long calls. It's a smarter approach because it's based on more informed assumptions about how options work. It boils down to choosing at-the-money options a few months from expiration on uptrending stocks that you believe are ready to pop.
These factors are all meant to increase the likelihood that the trade could be profitable. When you trade stocks, you only need to be right about price to be successful. With options, especially long calls, you often need to be right about price, time, and volatility. Make no mistake: Even with this smarter approach we're talking about, it is still speculative and directional. If you're looking for something less speculative, consider defined risk-return strategies like vertical spreads.
So, how do you set up a long call? First up, you've gotta choose an underlying. This could be a stock or ETF. Consider highly liquid assets that are already in an uptrend as opposed to looking for big event moves. Of course, there's no guarantee that upward trend is going to continue, but it could increase your probability of success.
But for a long call, we need more than just an uptrend; we need significant upward movement in a short amount of time, typically five to 15 days. That's where technical analysis can help.
Animation: A small chart of candlesticks shows the price rising, falling for three days, and rising again. Lines are drawn above the tops of the candlesticks and below the bottoms.
Narrator: A chart pattern like a close above the high of the low day could be a signal that a stock is bouncing off support and potentially ready to make an upward move. This can serve as an entry signal for timing the trade. Let's go back to thinkorswim and get into it.
On-screen text: Disclosure: Securities for illustrative purposes only and should not be considered endorsements, solicitations, or recommendations to purchase, sell, or hold these securities.
Narrator: So, here's a one-year, one-day chart of Disney, ticker DIS. You can see we've got a 50-day simple moving average added to it, which is uptrending. It also has an average daily volume well above 1 million, so it's liquid.
Animation: A horizontal support line appears around $147.
Narrator: And here you can see the stock is trading above its moving average trendline. If we zoom in, we can see it recently bounced off a previous price ceiling. And, finally, it's in position to close above a recent low day.
To a technical trader, all of this may point to a potential near-term jump. This will be our entry signal. Once you've chosen an underlying, you've got to select a contract. In short, we're looking for highly liquid options with plenty of time to expiration and without inflated implied volatility.
The first part of that decision is choosing your expiration. Even though you may only be planning to be in the trade for a few days to a few weeks, consider going much further out for your expiration—think 50 to 100 days.
For this example, that's the 19th of February expiration, which is 80 days out. Remember, we don't plan on holding the option all the way to expiration, we're just trying to take advantage of a projected price move and get out.
I've already mentioned that one of the common mistakes is not buying enough time. You don't want to be right about the price movement and still lose money because you didn't buy enough time. If you buy an option that expires in 90 days, but the stock hits your price target in six days, you just get out and sell all that remaining time. You might also want to make sure there aren't any earnings or news announcements coming up that could impact the stock movement. Disney just had earnings, so we don't have to worry about that.
Next, let's take a look at the strikes. The in-the-money strikes are more expensive, but you can see by looking at the delta, they have a higher probability of expiring in the money. The out-of-the-money options are less expensive, but, like we discussed before, their probability is lower.
So, you may want to consider something right in the middle: at-the-money, moderate costs with moderate probability.
Animation: The bid and ask prices on the options table are highlighted, and <10% appears on screen.
Narrator: And remember that we're looking for high liquidity. A way to gauge that is looking for a low bid/ask spread; one guideline options traders often use is that the difference between the bid and the ask should be no more than 10% of the ask price. A tighter spread means you're more likely to get your order filled at your desired price.
For this example, we'll use the 150-strike. It's quoting me a buy price of $9.35, which means I'd pay $935 per contract plus any commissions and fees to enter the trade. Now, we'll talk about risk management and exit considerations in a minute, but one thing we can do right off the bat is to buy our call with a stop order. This can help manage risk by automatically triggering an order to close the position if the price of the option falls to a price we set.
You typically load up a buy order in thinkorswim by just left-clicking the ask price, but to buy the contract with a stop, I'll right-click the Ask price, point to Buy custom, and select with STOP. It'll pull up some trade details at the bottom of the screen. Let's walk through the order ticket. The first item is a green row, showing we're buying. Below it is the red stop order.
Our next step is to figure out just how many contracts we want to buy. Position sizing is one of the main ways you can manage your risk, which is crucial to trading long calls. Like I said before, even the higher-probability approach we're discussing here is still very speculative. And even though the risk is limited to the amount paid in premium, if you allocate too much going after big returns, you can easily blow up your account.
To determine how many contracts to buy, you need to know two things: your portfolio risk and your trade risk. Portfolio risk is the total amount of your portfolio you're willing to lose on a given trade. Consider setting aside no more than 1% of your active trading portfolio per trade. Some traders put as little as half a percent.
Animation: The equation "Trading portfolio multiplied by 1% = Portfolio risk" appears on screen.
Narrator: So, for simplicity, let's say I'm trading with a $100,000 portfolio. If I'm willing to lose no more than 1%, my portfolio risk would be $1,000 per trade.
On-screen text: A warning sign with the words Trade risk appear on screen. The long call premium is $3 multiplied by 100 to equal $300.
Narrator: Next is trade risk, which is the amount you could lose in a given trade. For a long call, the trade risk is the premium you pay to buy the contract plus any commissions and fees. Even though we're using a stop order, there's no guarantee it'll fill, so we'll use the full premium.
On-screen text: The equation "Portfolio risk divided by Trade risk" appears on screen and then the words are replaced with the relevant numbers.
Narrator: For our example, the trade risk is $935 per contract plus the contract fee. Now that we know our portfolio risk and trade risk, we can figure out how many contracts to buy. To do this, take your portfolio risk and divide it by your trade risk. So, our portfolio risk of a thousand divided by the premium of $935 equals one contract.
Once you get more familiar with trading long calls, you can start factoring your stop order into your trade risk, but to start out, you'll want your position size based on the full premium.
Let's finish entering the sell-stop order. A common stop management technique is to place the sell order at about 50% of the purchase price of the option. For our trade that would be about $4.70. So, I'll just update the price with that.
Also, we want to make sure the stop order stays in force for the duration of our trade. So, I'll open the Time In Force menu, and select GTC: Good Til Cancelled.
On-screen text: Sample exit rule, Place a stop order at 50% of the options price.
Narrator: Before we actually send the trade, let's think about how we might get out of it. Options trades can move really quickly, so you'll want to set some firm exit rules. You already established one exit rule by setting a stop order at 50% of the options purchase price. This rule is pure risk management, as it may help prevent your trade from losing all of its value. If your stop is hit, chalk it up as a loss and move on to the next trade.
On-screen text: Sample exit rule, Price target on the stock, Specific dollar gain, Specific percentage gain on the option.
Narrator: But just as important as managing losses is managing profits. If the trade is going your way, you might be tempted to just let it ride and rack up the returns. But with options, things can change fast, and potential profits can evaporate in the blink of an eye. To keep greed in check, consider setting a firm profit target. This could be a price target on the underlying stock, a specific dollar amount gained, or a specific percentage gained on the option.
For example, let's look at how a trader might pick a price target on Disney (DIS). In recent weeks, on two separate occasions, the stock moved up about $12 as momentum shifted from bearish to bullish. With today's bounce off an apparent floor at $147, a trader might anticipate a price target of about $159.
Just keep in mind that past performance is not a guarantee of future performance. It can be tough to stick to a target and walk away from potential profits, especially when things are going well. But, even if it sometimes means leaving money on the table, having consistent exit rules can help protect you from losses over time.
Of course, there will be times when a trade doesn't go your way. There's always your stop order, but what if the trade doesn't move against you enough to trigger the stop, or it goes up but not quickly enough? How long should you wait around for the underlying stock to go where you want it to?
On-screen text: Sample exit rule, Exit if the stock price hasn't moved at least half as much in half the time.
Narrator: The last exit rule to consider is exiting if the stock price hasn't moved at least half as much as you expected in half the time you anticipated. For the type of strategy we're discussing, a common time frame could by anywhere from a few days to a couple weeks.
For Disney, the previous moves have happened within a week. So we'll say that if the stock hasn't reached $153 in the first few days, it may be time to think about getting out of it. If this happens, it means you haven't timed the option properly and time is of the essence.
You'll also want to think about bailing if the underlying closes below technical support levels. This is what's known as a counter-indicator, and it may suggest the trend is reversing. Closing the trade at this point could save some capital.
On-screen text: The thinkorswim Order confirmation window appears. The Max Loss row on the window is highlighted.
Narrator: Ok, now that you have some considerations for when to get out of the trade, let's go back to the Trade tab and place our order. Let's make sure everything looks right and then hit Confirm and Send. Our maximum gain is unlimited, like we talked about before. Our maximum loss shows here as the full premium, which is possible, but remember, we've set a stop order at 50% of the options premium, which could help reduce our losses.
If the stop is triggered, it'll send a market order and compete with other market orders at that time, so there's no guarantee it'll fill at the 50% price. Also note the transaction fee. If we're ok with this, let's go ahead and hit Send. And there we go. We've just bought a long call.
Now let's take a moment to break down how different factors like stock price, time, and volatility could impact this trade. I'll open up the risk profile in the Analyze tab to play around with the numbers.
First, I'll select the position. Now we can see from the risk profile that our max gain is unlimited, our max loss is limited to the premium we paid (though that doesn't account for our stop order), and our break-even point is about $159.35 at expiration, but remember we're planning to exit long before expiration.
The factor that will affect us the most is the stock price, so let's see what happens when price changes using the price slice feature. I'll set some price slices to show the stock rising or falling $10. The stock is currently trading at $150.54. If the stock price goes up by $10, you can see a hypothetical gain of about $630. Of course, if the stock price goes down by $10, we could lose about $445. But how does time factor into the profit or loss of this trade?
Let's move the date forward a week and assume the price of the underlying stays the same. We've got a potential loss of more than $32 in one week thanks to time decay. But what about vega? If implied volatility rises, our options value could go up, and if implied volatility falls, our options value could go down.
Let's take a look at a fairly big change in implied volatility, just to illustrate the point. First, I'll reset our date. Then I can click the gear icon to reveal the implied volatility adjustment. I'm going to give us a little more space here. Now, if I increase implied volatility by 5%, we'll see the projected unrealized gain of around $155; if we move it down by 5%, we can see a projected loss of about $125.
On-screen text: Managing a long call.
Narrator: Remember, placing a trade is just the beginning. This is an active strategy, so you'll want to monitor closely with your exit rules in mind. To show you how to do this, let's head back to the Monitor tab and look at a long call I've already got on our demonstration account.
I'm going to look at some calls we bought on Starbucks (SBUX). If we click on quantity, we can see on the 24th we bought four of the February 19 97.50 calls for $5.30 each. We do have a small profit right now, but let's revisit the technical logic of the trade.
I'll pull up the chart of Starbucks. You can see we had an upward trending moving average, price was trading above the moving average, and we had closed above a recent low day. We can also see that on the two previous bounces the stock had sizeable upswings in the following week. On the 24th, we were anticipating the stock would move a similar distance in a similar timeframe, giving us a target around $106.
Unfortunately, Starbucks has only drifted sideways, and is only slightly above that entry price. One of the potential exit rules we discussed earlier was exiting if the stock has not moved half the distance in half the time frame. And here we can see that over the course of four days, the stock has only moved about a dollar. This could mean our timing was off on this trade, and it's time to pull the plug.
And again, it may be tempting to try to justify staying in since it's slightly profitable, but a key to success with long calls is to follow your rules consistently. So I'm going to show you how to close out of this position.
To do that, I'll right click on the position and click Create closing order. So you can see on the order ticket we're selling our four contracts at $5.55 each. I'm using a limit order and leaving the time in force as day. I'll click Confirm and Send, but keep in mind that the max profit and loss don't apply to a closing order. Also note the transaction fee. Everything looks good, so we'll send the order.
Remember that we used a limit order, so there's no guarantee it will fill. And that's a smarter way to trade long calls. Remember, even though the approach we discussed may be higher probability and less risky than others you'll see out there, it's still risky.
Make sure you practice paper trading to get a feel for how these trades can move. Check out our other options education and keep learning.
On-screen text: [Schwab logo] Own your tomorrow®
