Strategy Talk Post - 3/1/2024 - What are Long Calls and Long Puts and how do they work?

Hi readers! This is the Strategy post for this week! Today, I will be going more in-depth and explaining the difference between a call option and a put option. This post will cover just long calls and long puts, however, I will also talk about how options are low risk. I hope you enjoy learning about them!

I highly suggest reading last week's strategy post to get familiar with the options trading lingo that traders use, so you can better understand the language in this week's post.

A call option is an option that enables the holder to purchase the underlying stock at a pre-determined price, which is what we call the strike price. A call option is In the money (ITM) when the underlying stock is above the strike price.

For example, if I bought a NKE call option at a strike price of $300, and if Nike goes to $320, then the call would be in the money, since 320>300. This would also make you a profit, because even though Nike is trading at $320, you have the right to buy it at $300 thanks to the option. So, you would exercise the option to buy NKE at $300, and then sell it at the market price of $320. This makes you a profit of $20, and shows how options can be really valuable. 

But wait, buying options are not free! Remember the premium? When buying options, you always pay a premium. What about in this case? Let's say you paid $3 for the NKE long call option in the previous example. So, you made $20 but paid $3 to do that. So you really made $17 off of exercising that call. This is where knowing the breakeven points of options come in handy.

What are breakeven points? Breakeven points are specific price points that the underlying stocks need to cross for the options to start making true profit. In this case, if the strike price of the NKE long call was $300 and you paid $3 for that option, the breakeven point would be $303, since after that point you start making true profit. Keep in mind that the long call is still ITM when NKE is above $300, it is just that you start making a true profit when it starts going above $303. 

Now let's look at put options. Put options are options that enable the holder to sell the underlying stock at a pre-determined price, the strike price. A put option is ITM when the underlying stock price is below the strike price of the put option.

For example, if I bought a put option on AMZN at a strike price of $400, and if AMZN goes to $380, then the put option is ITM since 380<400. How do you actually exercise a put option? Since the strike price is $400, you would sell shares of AMZN at that price. However, then you would be just net short shares, so you would have to buy back shares. Since the market price for AMZN shares is only $380, you would only buy the shares back at $380 a piece. This means that you made 20$ per share.

Now let's take premium into account. Let's say you bought the put option for $4, so then you made a true profit of $16. The breakeven point in this case would be the premium subtracted from the strike price, instead of addition (only for long calls). So the breakeven point would be $396. This means that the option starts picking up true profit when AMZN starts going below $396.

Now, if you make a dollar in options for every dollar in stocks, why not just buy and sell stocks? After all, you make all the profit and don't need to consider the premium when dealing directly with stocks, right? That is true; however, options provide leverage and risk management. Let's see how.

In the previous long call example, the breakeven point was $303, so NKE needs to go above that for the option to make profit. But what if NKE does not go above $303? Say Nike suddenly announces the release of an absolutely ugly shoe, and the stock price plummets from $310 to $200. If you had directly owned shares of NKE, then you would have lost $110 per share. Yikes! But what if you had the calls instead? You could just not exercise the calls, and you just lost the premium you paid up front for the call. So you would just lost $3 per option you bought. Personally, I think losing $3 instead of $110 is way better. This is how options are extremely useful, and this same scenario can be applied to puts, just in a reverse logic. For puts to be worthless, the stock must go above the strike price. In that case, you would just choose not to exercise the put option and lost the premium on them.

Options provide you with a dangerous amount of leverage, and when utilized properly, can yield high amounts of profit. I hope these examples were clear enough for you all to further understand how long calls and puts work, and I hope you learnt how breakeven points work and how options are amazing with leverage and risk management!

In next week's post, I will briefly go over this topic and use charts to illustrate breakeven points. I will also discuss how SHORT options work, and how they make money and how to utilize them. Thanks for reading, and I will see you in the next post!