Buying a Call Option

If you’re of the opinion that a certain commodity will INCREASE in price within a SPECIFIC period of time, then you should consider buying a call option.

If the events prove you wrong, and the price of the underlying commodity you’re trading the option on either goes down, or doesn’t move at all, the maximum you’ll lose is the premium you paid for the option, plus commissions and transaction costs. On the other hand, if the events prove you right, you stand to make unlimited profits.

BUYING A CALL OPTION
As the price of the underlying commodity  increases,
the value of the call option increases


Before you purchase a call option, you’ll need to consider a few things. First, you need to look at the length of the option.

Should you buy an option that’s 2 months, 3 months, or 6 months away from expiration? There’s no exact answer since every situation is different, and it’ll ultimately depend on your strategies and objectives. Just remember, options are a wasting asset. You only have a specific number of months in which to achieve your profit objectives. Otherwise, you lose your premium. The greater the length of the option, the better the chances of the option increasing in value. However, length has an impact on how much you’re going to pay for that option. A longer option will normally cost more. And the more you pay for the option the greater your break-even point.

This leads us to the next thing you’ll want to know: what will the underlying futures price have to be for the option to break even?  To calculate this you just need to know 3 elemental things:

1.  Strike price of the option.                                                                            

2.  The premium of the option.

3.  Commissions and transaction costs.

   Once you know these three things, determining the break-even price is easy:
 

CALL BUYING BREAK-EVEN POINT

Break-even price   = Strike price + Premium + Commissions & Transactions  

Example: You buy a wheat call option with a strike price of 350 (Represents $3.50 a bushel. Wheat trades in bushels per cent, so it’s often just abbreviated in the financial newspapers as 350).

You pay a premium of $400, plus $50 for commission and transaction costs. The current market price of wheat contracts is $3.50 a bushel. Based on these figures, your break-even price is $3.59 a bushel. Here’s the math:

1st)  Strike price $3.50 

2nd) Find out what the $400 premium translates into at cents per bushel. Wheat trades
        in 5,000 bushels so: 
$400 / 5,000 bu =  0.08 = 8 cents 

3rd)  Find out what the $50 commission and transaction costs translate into at cents
         per bushel:
$50 / 5,000 bu = 0.01 = 1 cent

4th)  Break-even = $3.50 + .08 + .01 = $3.59


Next, since options trade down to fractional values as small as sixteenths of a point, I thought it would be a good idea to include a fractional values chart, even though throughout our examples we’ll be rounding off:

   Fraction           Dollar Value
       1/16                                         $ 6.25
        1/8                                            $12.50
       3/16                                          $18.75
        1/4                                           $25.00
       5/16                                          $31.25
        3/8                                           $37.50
       7/16                                          $43.75
        1/2                                           $50.00

      9/16                                          $56.25
      5/8                                             $62.50
     11/16                                          $68.25
      3/4                                            $75.00
    13/16                                          $81.25
      7/8                                            $87.50
    15/16                                          $93.75
       1                                             $100.00

 

Let’s illustrate buying a call with some examples. We’ll look at buying call options that are in the money, at the money, and out of the money.

Examples:

Suppose it’s February. You’re considering buying a June 600 Silver call option because you believe the price of silver is going up (This means that the option would actually expire sometime in May. Remember, the stated expiration month corresponds to the expiration of the futures contract, not the option. Options expire 1 month earlier.) COMEX silver trades for 5,000 troy ounce contracts in cents per ounce (see chapter seven for price/unit specifications.) The current market price is 600 cents per troy ounce ($6.00 per ounce). Therefore, this call option is at the money. Right now, it’s got no intrinsic value.

But since you believe the price of silver will rise sometime between February and May, you pay a premium of $750 (that’s 15 cents per troy ounce) plus commissions and transactions of $100 (that’s 2 cents per troy ounce), and purchase the call.

Around March, the price of silver is up to 612 per troy ounce. This means that your option is now in the money. It has an intrinsic value of 12 cents per troy ounce. You’re up $600 (.12 x 5,000 = 600). If you sold it now you would recover your premium, but you would be out of your commission and transaction costs. Your break-even point is actually at 617. Obviously, it wouldn’t be profitable for you to liquidate it just yet.

In April, the price of silver increased to 617 per troy ounce. You’re up $850. Minus the $750 premium and the commission you paid, you find that you just broke even. So now you’ve got to make a decision. The expiration date is getting closer, and you have a chance right now to liquidate and break even. At this point, if you hold onto it, there’re a few possible scenarios: 

a)  The price of silver keeps going up and you offset your option before the
      expiration date and make a profit.

b)  The price remains pretty much the same and you break even.

c)  The price suddenly turns in the other direction, so you offset your option
      before the expiration date and incur a partial loss.

 d)  The price suddenly turns in the other direction, the option expires and you
       lose it all.

         
Let’s look at how you would handle each scenario:

Scenario a)  In early May, the price of silver jumps to 680 cents an ounce. When you had originally purchased this call option it had $0 intrinsic value. Now it has $4,000 of intrinsic value (.80 x 5,000 = 4,000). You quickly liquidate the option and realize a profit of $4,000 minus the $750 premium and the $100 commission and transaction costs you paid. 

Scenario b) By the expiration date in late May, the price of silver is holding at 617 cents an ounce. You liquidate the option and make a profit of $850 minus the $750 premium and the $100 commission and transactions costs. In other words, you break even.

Scenario c) In early May, the price of silver begins to turn against you. It went down from 617 to 614, and now it’s at 610. You decide enough is enough, it’s time to jump off the boat and offset your option before it’s too late. When you liquidate your option you make $500 (.10 x 5000 = 500). Minus the $750 premium and commissions paid, you come out losing a few hundred dollars. However, you decide that it was better to take a limited loss, rather then wait for expiration and risk perhaps your entire investment.

Scenario d) Same scenario as in c), only this time your reasoning is different. You feel there might be a late month surge in the prices of silver, and hold onto the option. But instead, prices continue dropping to 580 an ounce. This put your option out of the money. It expires, and you lose $750 plus commissions.

 

The following chart illustrates what went on in this example. Notice how our call option began gaining intrinsic value once the underlying silver futures contract rose above the strike price of 600:

Call Option on June Silver

 

call option chart

The a) line is our option climbing to 680 an ounce. The d) line is our option losing ground all the way down to 580 an ounce. In the middle, is our strike price at 600. We figured our break-even point to be at 617.

 


Defining Your Profit Objectives

You can see by our previous example how important it is to plan ahead, and have definitive profit goals before you start trading an option. As the price fluctuates, you’ll be making some decisions. So before you trade, decide:

                   1.  How much of the premium are you willing to lose if things
                     
    go wrong?                             

                   2.  How much of a profit are you satisfied with if things go  
                        
well?                         

 Knowing when to enter and when to exit a trade is key to earning profits!

Now let’s analyze our example a little further. Suppose it’s February and you’re very bullish on silver. You’re expecting it’s going to shoot up over the next few weeks. The price of silver is currently 600 an ounce. You decide on a 350 May silver call option. This means it’s already in the money, with an intrinsic value of 250 cents an ounce. That’s a $12,500 profit just for buying the call. What a deal!, right?  Well, not exactly. Because the premium you’re going to be asked to pay for this call will also be higher. In fact, you may pay a 248 cents premium. This translates into $2.48 cents an ounce, which amounts to $12,400 (2.48 x 5,000 = 12,400) plus commissions.

So, even though you have intrinsic value built-into, you’re right at about you’re break even point depending on your commission fees.

On the other hand, suppose you want to buy a cheaper option. It’s February, and you choose a 625 July silver call option. Say the price of silver is currently 525. You’re 100 cents out of the money. There’s no intrinsic value in this option. However, you feel the price of silver will go up substantially by June (volatility), and you pay a premium of 4 cents an ounce for the option. This amounts to $200 (.04 x 5000 = 200), plus commissions.

Let’s say your predictions were right, and the price of silver climbs to 700 by June. Now you’re option is in the money, with an intrinsic value of 75 cents an ounce. You liquidate the option and make a profit of $3,750 (.75 x 5000 = 3,750), minus the $200 premium and the commissions. A great return, considering that if had you been wrong about the direction in the price of silver, you would have only lost the $200 premium plus commissions.

Finally, let’s close our example with one last scenario. Suppose this time, that instead of buying the 625 July silver call option, you wanted to give yourself more time for the price of silver to rise, so you buy the 675 September silver call option. The market price of silver is still at 525. Your call option, therefore, is 150 cents deep out of the money. Yet, you’re asked to pay a premium of 9 cents an ounce. In other words, $450 (.09 x 5000 = 450). The reason you’re paying a higher premium with the September option than with the July option, is because you’ve got a couple of extra months to realize a profit. Simply, the more time you allow, the greater the likelihood that the option will become profitable. With a shorter expiration date, you have a greater risk that the option will expire before the underlying commodity increases in value.

Recapping what we’ve just covered, we’ve seen how an option that’s in the money commands a higher premium. And the farther away the expiration date is, the higher that premium will be. On the other hand, when an option is at the money, or out of the money, the premium is lower. But just as with the in the money option, the farther away the expiration date is, the higher the premium.

 

Advantages And Disadvantages Of Buying Call Options

The plain fact here is that most call buyers lose money. Even when the underlying commodity increases in value, it may not increase enough. Not only must you be right on which direction the commodity is going to move, but the degree of movement must be big enough to produce a profit within the limited time before expiration of the option. Yet, they do offer some attractive features:

Advantages

  • Limited risk – If the price of the commodity drops, you’re total possible loss is the purchase price of the option plus commissions.
     
  • Small capital commitment -The cost of buying an option is substantially lower compared to the cost of a futures contract (or most any other asset.)
     
  • Unlimited profit potential – Even though your risk is pre-defined, your potential for profits are virtually unlimited.
     

Disadvantages

  • Lower probabilities – It’s difficult to consistently guess correctly the timely price direction of the market.

So why do people buy call options? Well, one reason is that it could be part of an overall strategy, as we’ll see later on. Another reason, is that even though the odds work against you, it’s possible that with a few profitable options you can more than make up for losses incurred with the other not profitable options.


Next: Buying a Put Option