Knowledge Base

What is a Long Call Strategy

in Trading Strategies
Tags: long calltrading strategy

The stock market is often viewed as a gamble. Yet, patience is the biggest virtue on the street. A wise investor always waits and watches before jumping in to catch the game. It is all about right timing and the right price on the street. And this may often take long.

This is where a long call strategy comes into play. Let’s take a look:

What is a long call strategy

A Call Option is a contract that allows you to buy a given amount of an asset, such as a stock, currency, commodity or index, at a specific price at a future date (called expiry date). Exercising the Option is completely up to your discretion. You may not exercise it if you do not see an incentive in doing so. For purchasing an option, you have to pay a small price called premium.

A long position in derivative language refers to a ‘buy’ position in an Option. Thus, entering a long call means buying a Call Option. To offset a long call position, one must sell a similar Call Option. This is called shorting a call.

Uses of a long call strategy

A long call strategy is primarily used as a tool for benefiting from the appreciation in the price of the underlying asset. If you as an investor feel that an asset will appreciate, you will go long on a call on the asset at a strike price equal to or lower than the current market price.

Whenever you feel that the asset has appreciated enough before expiry, you may close this position by shorting a similar Call Option. Thus, you earn the difference between the strike prices of the two. If you feel the asset can appreciate further, you may not offset this position and benefit from the difference in the market price upon expiry and the strike price. You may also leave the Option unused if the price is below the strike price even upon expiry. In this case, you will only lose the premium.

How a long call strategy works

Let us try to understand the long call strategy through an example.

Assume that the Nifty index is currently at 8,500 and you expect it to appreciate. You may then go long on one lot of Nifty Call Options (comprising 25 Nifty shares) with a strike price of 8,500 and an expiry of one month. This would effectively give you a long position worth Rs 2,12,500 in the index for a much smaller price (premium). If the Nifty appreciates to say 9,000 before expiry, you will liquidate your position by shorting a similar Call Option and make a gain of Rs 500 per share or Rs 12,500. On shorting the Call, you will receive a premium that will nullify the premium you paid earlier. Thus, you would effectively make a gain of Rs 12,500 without any premium payments! You may also leave this position open till expiry and gain from the difference between the market price and the strike price then. If neither appears beneficial, you could simply let the Call expire and only lose the premium.

Hedging using long call strategy

Investors may also use a long call strategy to limit losses from the short sale of an asset. This is called hedging. A short sale occurs when one borrows and sells an asset to buy it later, profiting from a probable fall in price. Such investors face the risk of the asset appreciating, thus forcing them to buy the assets back at a higher price and making a loss. A long call strategy with a strike price equal to or lower than his purchase price enables him to buy the asset at this price in future, even if its market price becomes higher. Thus, the long call strategy can help eliminate his loss.

Benefit of long call over cash position

The profit an investor makes by using a long call strategy can also be made by simply purchasing the asset in the market and selling it later, when it appreciates. However, this requires him to pay the entire price of the asset rather than a small premium required to buy the call. Further, once he has the asset in his possession, he is obligated to sell it even if only at a loss. In case of the option, he can simply not exercise the option if prices are unfavorable and limit his loss to the premium. This is why a long call strategy is preferable to buying the asset outright.