Long Stock Options Strategy

8 min read

Long Stock

Description

This strategy simply consists of buying shares of the underlying stock. The purchase price sets the cost basis, and the exit price establishes whether there is a net profit or loss on the asset. No gain or loss is final until the stock is actually sold. (However, once received, dividend income of course belongs to the stock owner.)

Stock exit plans vary widely and are not very relevant to the text of an option. It’s enough to note two examples here. One system is to buy and hold a stock indefinitely; exit occurs only if the fundamentals change significantly. Other investors re-evaluate each equity against performance targets, asset allocation goals, or at certain time intervals, and then sell the ones that seem overweighted or overvalued.

Factors such as tax considerations or employment-related stock holding rules could also affect the timing and desirability of a sale. Stock owners who want to lock in existing gains without liquidating the equity may be candidates for an option hedge.

Outlook

The investor is bullish on the stock and/or the equity market as a whole.

Some buyers are bullish in the long term, while others act in expectation of short-term gains. It is the investor’s decision whether to buy and hold indefinitely or to trade in and out in hopes of a quick profit.

If an investor is bullish in the long run but very concerned about a near-term correction, there may be other, more suitable alternatives than a standalone long stock strategy.

Summary

This strategy is simple. It consists of acquiring stock in anticipation of rising prices. The gains, if there are any, are realized only when the asset is sold. Until that time, the investor faces the possibility of a partial or total loss of the investment, should the stock lose value.

In some cases, the stock may generate dividend income.

In principle, this strategy imposes no fixed timeline. However, special circumstances could delay or accelerate an exit. For example, a margin purchase is subject to margin calls at any time, which could force a quick sale unexpectedly.

Motivation

The stock buyer hopes to profit from gains in the stock’s price, and, sometimes, with dividend income.

The stock selection itself could be based on any number of reasons: a personal interest in this specific stock, employer incentives to accumulate shares, or a desire to diversify a portfolio, for example.

Variations

Stock can be acquired by various means: e.g., via a direct cash purchase, through an employer, an inheritance, or a margin purchase. The method could dictate a different way of establishing a cost basis and/or restrict the timing of an exit. For purposes of this summary, the investor is assumed to be buying a stock outright, in the market, for cash.

Max Loss

Profits rise along with the stock’s value. Theoretically, the best that can happen is for the stock to rise to infinity, in which case the gain would also be unlimited.

Dividends, if there are any, add to the net profit.

Max Gain

The maximum gain would occur should the underlying stock go to infinity. If the strategy is analyzed as a bear call spread and a long call combined, then when all the options go deep in the money, the bear call spread has a negative value equal to the difference between the strikes, and the long call has a positive value equal to the difference between the stock’s price and the upper strike price. Since there is no limit to the stock’s upside potential, the option strategy’s potential gain is also unlimited.

Profit/Loss

There is no upper limit to the potential for profit.

By the same token, potential losses are also substantial; if the company goes bankrupt its stock could fall to zero, for a total loss amounting to the initial cost, less any dividends received to that point.

Breakeven

This strategy breaks even when the stock is trading at the price paid at the outset.

Breakeven = purchase price of the stock

(An aside worth noting here: This strict definition of breakeven obviously ignores the time value of money. If a stock trades at its acquisition price years later, the result has to be seen as an economic loss, because of the capital the stock ties up and the risks involved.)

Volatility

The concepts of volatility and especially implied volatility don’t apply quite in the sense that they do to option positions. However, if the stock becomes more volatile, it increases the potential for larger losses as well as larger profits. And if the stock has been purchased on margin, it increases the likelihood of having to meet margin calls.

Time Decay

Not relevant.

Assignment Risk

None

Expiration Risk

None

Comments

Though the concept of time decay does not apply to stock, the passage of time is a consideration for a stock buyer. Since owning stock ties up capital, the investor incurs an opportunity cost while holding the stock. That could be one consideration in evaluating alternative bullish strategies.

On a different note, stock can sometimes be acquired on margin. Margin availability is governed by regulatory constraints as well as the brokerage firm’s internal guidelines, which may be more stringent. The investor must secure all necessary preapprovals first. Also, margin purchases are subject to margin calls. Please consult your brokerage firm to learn more about margins.

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Content licensed from the Options Industry Council is intended to educate investors about U.S. exchange-listed options issued by The Options Clearing Corporation, and shall not be construed as furnishing investment advice or being a recommendation, solicitation or offer to buy or sell ant option or any other security. Options involve risk and are not suitable for all investors.