A Call option gives the owner the right, but not the obligation to purchase the underlying asset (a futures contract) at the stated strike price on or before the expiration date. They are called Call options because the buyer of the option can “call” away the underlying asset from the seller of the option. In order to have this right or choice the buyer makes a payment to the seller called a premium. This premium is the most the buyer can lose, as the seller can never ask for more money once the option is bought. The buyer then hopes the price of the commodity or futures will move up because that should increase the value of his Call option, allowing him to sell it later for a profit. Let’s look at a couple of examples to help explain how a Call works.
Real Estate Call Option Example
Let’s use a land option example where you know of a farm that has a current value of $100,000, but there is a chance of it increasing drastically within the next year because you know that a hotel chain is thinking of buying the property for $200,000 to build a huge hotel there. So you approach the owner of the land, a farmer, and tell him you want the option to buy the land from him within the next year for $120,000 and you pay him $5,000 for this right or option. The $5,000 or premium, you give to the owner is his compensation for him giving up the right to sell the property over the next year to someone else and requiring him to sell it to you for $120,000 if you so choose. A couple of months later the hotel chain approaches the farmer and tell him they will buy the property for $200,000. Unfortunately, for the farmer he must inform them that he cannot sell it to them because he sold the option to you. The hotel chain then approaches you and says they want you to sell them the land for $200,000 since you now have the rights to the property’s sale. You now have two choices in which to make your money. In the first choice you can exercise your option and buy the property for $120,000 from the farmer and turn around and sell it to the hotel chain for $200,000 for a profit of $75,000.
$200,000 from the hotel chain
—$120,000 to the farmer
—$5,000 for the price of the option
Unfortunately, you do not have $120,000 to buy the property so you are left with the second choice.
The second choice allows you to just sell the option directly to the hotel chain for a handsome profit and then they can exercise the option and buy the land from the farmer. If the option allows the holder to buy the property for $120,000 and the property is now worth $200,000 then the option must be worth at least $80,000, which is exactly what the hotel chain is willing to pay you for it. In this scenario you will still make $75,000.
$80,000 from the hotel chain
—$5,000 paid for the option
In this example everyone is happy. The farmer got $20,000 more than he thought the land was worth plus $5,000 for the option netting him a $25,000 profit. The hotel chain gets the property for the price they were willing to pay and can now build a new hotel. You made $75,000 on a limited risk investment of $5,000 because of your insight. This is the same choice you will be making in the commodity and futures options markets you trade. You will typically not exercise your option and buy the underlying commodity because then you will have to come up with the money for the margin on the futures position just as you would have had to come up with the $120,000 to buy the property. Instead just turn around and sell the option in the market for your profit. Had the hotel chain decided no to but the property then you would have had to let the option expire worthless and would have lost the $5,000.
Futures Call Option Example
Now let’s use an example that you may actually be involved with in the futures markets. Assume you think Gold is going to go up in price and December Gold futures are currently trading at $1,400 per ounce and it is now mid-September. So you purchase a December Gold $1,500 Call for $10.00 which is $1,000 each ($1.00 in Gold is worth $100). Under this scenario as an option buyer the most you are risking on this particular trade is $1,000 which is the cost of the option. Your potential is unlimited since the option will be worth whatever December Gold futures are above $1,500. In the perfect scenario, you would sell the option back for a profit when you think Gold has topped out. Let’s say gold gets to $1,550 per ounce by mid-November (which is when December Gold options expire) and you want to take your profits. You should be able to figure out what the option is trading at without even getting a quote from your broker or from the newspaper. Just take where December Gold futures are trading at which is $1,550 per ounce in our example and subtract from that the strike price of the option which is $1,400 and you come up with $150 which is the options intrinsic value. The intrinsic value is the amount the underlying asset is though the strike price or “in-the-money.”
$1,550 Underlying Asset (December Gold futures)
—$1,400 Strike Price
$150 Intrinsic Value
Each dollar in the Gold is worth $100, so $150 dollars in the Gold market is worth $15,000 ($150X$100). That is what the option should be worth. To figure your profit take $15,000 - $1,000 = $14,000 profit on a $1,000 investment.
$15,000 option’s current value
—$1,000 option’s original price
$14,000 profit (minus commission)
Of course if Gold was below your strike price of $1,500 at expiation it would be worthless and you would lose your $1,000 premium plus the commission you paid.