Explaining Call Options (Short and Long)
What is a Call Option?
A call option is the right to buy the underlying futures contract at a certain price.
When traders buy a futures contract they profit when the market moves higher. The call option has a similar profit potential to a long futures contract. When prices move upward the call owner can exercise the option to buy the future at the original strike price. This is why the call will have the same profit potential as the underlying futures contract.
However, when prices move down you are not obligated to buy the future at the strike price, which is now higher than the futures price because that would create an immediate loss.
With this downside protection why would any trader buy a futures contract instead of call?
The potential to profit on a call option does not come without a cost. The seller or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a call option pays a premium to the seller of a call option.
As a result of the added cost of the premium, the profit potential for a call is less than the profit potential of a futures contract by the amount of premium paid. The price of the future must rise enough to cover the original premium for the trade to be profitable. Moreover, options premiums are impacted by time decay and changes in volatility (futures are not).
The breakeven point for a call is the strike price plus the premium paid. So if you paid 4.50 points for a 100 call option, the breakeven is 104.50. The most you could lose is the premium or 4.50 points.
For every long call option buyer, there is a corresponding call option “writer” or seller. If you sell the call option, then you receive the premium in return for the accepting the risk, that you may need to deliver a futures contract, at a price lower than the current market price for that future.
Option sellers have unlimited risk if the futures price continues to rise.
Call sellers will profit as long as the futures price does not increase beyond the value of the premium received from the buyer.
The breakeven point is exactly the same for the call seller as it is for the call buyer.
Call Buyers have protection in that their risk is limited to the premium they must pay for the call option. The maximum risk of a call option is the premium paid. They can lock in the strike price and profit (should the underlying rise far enough) while risking only the upfront premium paid.