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Introduction to Options

This course is reproduced with the permission of XPRESSTRADE Back to Trading 101 Index

Buying Call Options

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 114 call option, for instance, would convey the right to buy one March U.S. Treasury Bond futures contract at a price of $114,000 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 is simply sold for more than they cost. In general, the value of a call option can be expected to increase as the price of the underlying futures contract rises.

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 112 call. Assume the premium you pay is $1,000. You'll pay this amount at the time of the purchase, and you can expect to see it deducted from your account. If, at the expiration of the option (in May) the June T-Bond futures price is 116, your option -- which gives you the right to buy a futures contract at 112, which is below the prevailing market price -- is of some value. You can realize a gain of 4 (that's $4,000) by exercising or selling the option. Since you paid $1,000 for the option, your net profit is $3,000, less transaction costs.

The Trader Buys...

Futures Position Upon Option Exercise...

A call option

Long futures position at the strike price

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 $1,000 premium you paid for the option plus transaction costs. Risk is limited to a pre-defined maximum amount when you buy a call option, in other words, while your potential reward is unlimited.

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 $4,000. For someone with an outright long position in the June T-Bond futures contract, an increase in the futures price from 112 to 116 would have yielded a net profit of $4,000 less transaction costs. There's no premium to be paid when you trade a futures contract.

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 is held until expiration and finishes "out-of-the-money" -- in other words, it's not worthwhile to exercise.

Next chapter: Buying Put Options

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