Buying Call Options

» Posted by on Feb 3, 2012 in Uncategorized | 0 comments

The buyer of a call option acquires the right, but not the obligation, to purchase (go long) 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).

A March Treasury bond 92 call option would convey the right to buy one March U.S. Treasury bond futures contract at a price of $92,000 at any time during the life of the option.

One reason 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. Or a profit can be realized if, prior to expiration, the option rights can be sold for more than they cost.

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 90 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 93, you can realize a gain of three (that’s $3,000) by exercising or selling the option that was purchased at 90. Since you paid $2,000 for the option, your net profit is $1,000 less transaction costs.

As mentioned, the most that an option buyer can lose is the option premium plus transaction costs. Thus, in the preceding example, the most you could have lost—no matter how wrong you might have been about the direction and timing of interest rates and bond prices—would have been the $2,000 premium you paid for the option plus transaction costs. In contrast, if you had an outright long position in the underlying futures contract your potential loss would be unlimited.

It should be pointed out, however, that while an option buyer has a limited risk (the loss of the option premium), his profit potential is reduced by the amount of the premium. In the example, the option buyer realized a net profit of $1,000. For someone with an outright long position in the June T-bond futures contract, an increase in the futures price from 90 to 93 would have yielded a net profit of $3,000 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.

Reprinted with permission from the National Futures Association. Copyright 2002.

Disclaimer: Trading futures and options involves the risk of loss. You should consider carefully whether futures or options are appropriate to your financial situation. You must review the customer account agreement and risk disclosure prior to establishing an account. Only risk capital should be used when trading futures or options. Investors could lose more than their initial investment. Past results are not necessarily indicative of futures results. The risk of loss in trading futures or options can be substantial, carefully consider the inherent risks of such an investment in light of your financial condition. Information contained, viewed, sent or attached is considered a solicitation for business.

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