What Are Long Options and How Do They Work?

Options are financial contracts that provide the holder with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe. These instruments derive their value from an underlying asset, which can be a stock, an exchange-traded fund (ETF), a commodity, or an index. Options trading involves specific terminology and market dynamics, allowing investors to manage risk or generate returns based on their market outlook.

Understanding Long Options

Being “long” an option refers to buying an option contract. When an investor purchases an option, they acquire a right related to the underlying asset, distinguishing them from the seller, who takes on an obligation. The buyer pays a premium for this right, and their maximum financial risk is limited to this premium. The long option holder gains the ability to exercise their right if market conditions become favorable, but they are never compelled to do so.

This position contrasts with being “short” an option, where an investor sells an option and assumes an obligation to buy or sell the underlying asset if the option is exercised by the buyer. The buyer of an option controls the decision to exercise the contract, while the seller must fulfill the contract terms if exercised. Holding a long option provides a defined maximum loss, which is the initial cost paid. The buyer’s decision to exercise or let the option expire depends entirely on the financial benefit at expiration.

Key Elements of Long Options

Every long option contract is defined by several fundamental components that determine its value and potential outcome. The “underlying asset” is the security or commodity on which the option is based, such as shares of a specific company’s stock or an ETF. This asset is what the option holder has the right to buy or sell.

The “strike price,” also known as the exercise price, is the predetermined price at which the underlying asset can be bought or sold if the option is exercised. This fixed price is established when the option contract is created and remains constant until the option’s expiration. The “expiration date” is the final day on which the option contract can be exercised; after this date, the option becomes worthless if not exercised or closed. Options typically expire on the third Friday of the month, though weekly and quarterly options are also available.

The “premium” is the price an investor pays to purchase an option contract. This is the cost of acquiring the rights and represents the maximum loss for the buyer. Premiums are quoted on a per-share basis, even though one option contract typically represents 100 shares of the underlying asset. Therefore, the total cost for one contract is the premium multiplied by 100.

The relationship between the strike price and the current market price of the underlying asset determines whether an option is “in-the-money” (ITM), “at-the-money” (ATM), or “out-of-the-money” (OTM). An option is ITM when exercising it would result in an immediate profit, meaning the underlying price is favorable relative to the strike price. An ATM option has a strike price equal to or very close to the underlying asset’s current market price. Conversely, an OTM option has a strike price that would result in a loss if exercised immediately, and these options carry no intrinsic value.

Long Call Options

A long call option grants the holder the right to buy 100 shares of the underlying asset at a specified strike price on or before the expiration date. Investors typically purchase long call options when they anticipate an increase in the price of the underlying asset. This strategy allows them to profit from upward price movements without owning the shares outright.

The investor pays a premium for this right. If the underlying asset’s price rises above the strike price plus the premium paid, the call option gains intrinsic value. The investor can either sell the option for a profit or exercise it to buy shares at the lower strike price. For example, if a call option with a $50 strike price costs $2 per share, the break-even point for the investor is $52 per share.

The potential profit for a long call option is theoretically unlimited, as the underlying asset’s price can continue to rise indefinitely. The maximum loss is limited to the premium paid. This occurs if the underlying asset’s price does not rise above the strike price by the expiration date, causing the option to expire worthless. This defined risk makes long calls an attractive strategy for expressing a bullish market outlook.

Long Put Options

A long put option provides the holder with the right to sell 100 shares of the underlying asset at a specified strike price on or before the expiration date. Investors typically buy long put options when they expect the price of the underlying asset to decline. This strategy can also be used as a form of portfolio protection, similar to an insurance policy, against potential downturns in existing stock holdings.

The investor pays a premium for the right to sell. If the underlying asset’s price falls below the strike price minus the premium paid, the put option increases in value. The investor can either sell the option for a profit or exercise it to sell shares at the higher strike price. For instance, if a put option with a $50 strike price costs $2 per share, the break-even point for the investor is $48 per share.

The maximum potential profit for a long put option is substantial, occurring if the underlying asset’s price falls to zero. However, the profit is capped because an asset’s price cannot go below zero. Similar to long calls, the maximum loss for a long put option is limited to the premium paid. This is lost if the underlying asset’s price does not fall below the strike price by the expiration date. This defined maximum loss makes long puts a viable strategy for those anticipating a bearish market movement or seeking to hedge against downside risk.