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What is a Call Option?

 

The key purpose of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a manageable risk. The maximum loss to the buyer of an option is the cost of purchasing the option (known as the option "premium") plus transaction costs.

The buyer of a futuresí call option acquires the right but not the obligation to purchase a particular futures contract at a specified price at any time during the life of the option. Each option specifies the futures contract which may be purchased (known as the "underlying" futures contract) and the price at which it can be purchased (known as the "exercise" or "strike" price). For instance, a May option on frozen concentrated orange juice (FCOJ) has as its underlying interest one May FCOJ futures contract.

To buy an option costs money and this cost is referred to as the option premium. The holder can affect the purchase of the underlying interest by exercising the option. For example, a June Deutsche Mark call option having a strike price of $0.6355 might cost $350. Anyone willing to pay $350 - the option premium - can acquire this option which will give the holder the right to buy one June Deutsche Mark futures contract at a price of $0.6355 on or prior to the option's expiration.

The key intent for buying call options is to profit from an anticipated increase in the underlying futures price. A call option buyer will realize a net profit if, upon exercise, the underlying futures price is above the option exercise price by more than the premium paid for the option. Alternatively, a profit can be realized prior to expiration as the option rights can be sold for more than they cost. Although an option buyer cannot lose more than the premium paid for the option, one can lose the entire amount of the premium. This will be the case if an option held until expiration is not worthwhile to exercise.

For example: You expect lower interest rates to result in higher bond prices (interest rates and bond prices move inversely). To profit if you are right, you buy a June T-bond 82 call. Assume the premium you pay is $2,000. If, at the expiration of the option (in May) the June T-bond futures price is 88, you can realize a gain of 6 (that's $6,000) by exercising or selling the option that was purchased at 82. Since you paid $2,000 for the option, your net profit is $4,000 less transaction costs. In the example, the option buyer realized a net profit of $4,000. For someone with an outright long position in the June T-bond futures contract, an increase in the futures price from 82 to 88 would have yielded a net profit of $6,000 less transaction costs. Although an option buyer cannot lose more than the premium paid for the option, he can lose the entire amount of the premium. This will be the case if an option held until expiration is not worthwhile to exercise.

The seller of a call option receives the option premium but, in return, must sell the underlying interest to the option holder if the holder exercises the option.

An option position can be offset by entering an equal but opposite trade - for example, buying if you previously sold or selling if you previously bought. The difference between the price of the option when the trade was initiated and the price when it is offset is the net gain or loss on the trade. The holder of a profitable option may, alternatively, elect to exercise the option into futures, and then offset this new futures position at a profit. One may decide to do this if one believes that prices will continue to move favorably. In some cases, for instance, lack of market liquidity, the option holder may not be able to offset ones option position and may have to exercise it into futures to capture the profits.

Options as an investment

Option premium values fluctuate. Just like with futures, money is made if you buy an option and later sell it at a higher value, or sell an option and later buy it back at a lower value. Options have some attributes that make them different than futures as an investment.

Limited Downside Risk:

Buyers of options, whether a call or a put, have limited downside risk: The most that they can lose is the premium paid for the option, plus commissions. If prices move adversely after an option purchase, the holder will simply let the option expire worthless (without exercising it). Buyers of a futures contract, on the other hand, have no such protection. If prices move adversely after the futures purchase, the holder suffers all losses until the position is closed. While option buyers have limited downside risk, option sellers do not since an option seller must enter into a transaction at the discretion of the option holder, no matter how adversely prices have moved. For this reason, selling options is considered riskier than buying options.

Option Expirations:

Options are either exercised or allowed to expire worthless. Options will only be exercised if it is in the financial interests of the holder to do so. If an option is left to expire worthless, it is the option seller who benefits, as they were able to earn the full premium of the option that was received when the option was sold. An option that expires worthless also enables the option seller to get out of ones short option position without having to initiate an offsetting transaction.

Buyers of options must pay the full amount of the option premium upon purchase. Since full value has been paid, the option buyer will never face a margin call on a long option position, no matter how much prices move adversely. Sellers of options do not have this benefit and may be required to deposit additional margin if prices move adversely.

No Price Limits:

Markets for options on futures typically do not have price limits, even if the futures market operates with price limits. As a result, an option trader will not face a "locked-limit" market.

Variety of Strike Prices:

Options are listed with a variety of strike prices. Because strike prices differ, the premium of these options will also differ - some will be more expensive than others. This provides a lot of flexibility to the option trader. For instance, the call option buyer who is willing to risk only a small amount of money can buy a call option with a high strike price as it will have a relatively low premium.

Quoting Option Prices:

In the option-trading pit and in newspapers, option prices are quoted in terms of ticks, or minimum price fluctuations, and not the full price in dollars and cents. To determine the actual dollar cost of an option, you need to multiply the market price in ticks by the dollar value of a tick. (The tick value of an option is almost always the same as the tick value of the futures. This is determined by the futures exchange and detailed in the option contract specifications.) For instance, consider the example above of a June Deutsche Mark call option having a strike price of $0.6355. The price of this option might be quoted as $0.0028, or .28 cents, or just 28, which means 28 ticks. Each tick of a Deutsche Mark options contract (as well as a futures contract) has value of $12.50. Therefore, the dollar price of this option is 28x$12.50 = $350.

 
 
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