Buy Call
Why buy the right to buy the stock when you can simply buy the stock? All
option strategies have trade-offs, and the long call is no different. Whether
the stock or the call is preferable depends greatly on the trader’s forecast
and motivations.
Consider a long call example:
Buy 1 INTC June 22.50 call at 0.85.
In this example, a trader is bullish on Intel (INTC). He believes Intel will
rise at least 20 percent, from $22.25 per share to around $27 by June
expiration, about two months from now. He is concerned, however, about
downside risk and wants to limit his exposure. Instead of buying 100 shares
of Intel at $22.25—a total investment of $2,225—the trader buys 1 INTC
June 22.50 call at 0.85, for a total of $85.
The trader is paying 0.85 for the right to buy 100 shares of Intel at $22.50
per share. If Intel is trading below the strike price of $22.50 at expiration,
the call will expire and the total premium of 0.85 will be lost. Why? The
trader will not exercise the right to buy the stock at a $22.50 if he can buy it
cheaper in the market. Therefore, if Intel is below $22.50 at expiration, this
call will expire with no value.
However, if the stock is trading above the strike price at expiration, the
call can be exercised, in which case the trader may purchase the stock
below its trading price. Here, the call has value to the trader. The higher the
stock, the more the call is worth. For the trade to be profitable, at expiration
the stock must be trading above the trader’s break-even price. The break-
even price for a long call is the strike price plus the premium paid—in this
example, $23.35 per share. The point here is that if the call is exercised, the
effective purchase price of the stock upon exercise is $23.35. The stock is
literally bought at the strike price, which is $22.50, but the premium of 0.85
that the trader has paid must be taken into account. Exhibit 1.1 illustrates
this example.