Understanding Call Options

Understanding call options is not difficult. The difficulty comes when it’s time to learn how to
price break-even points on transactions in conjunction with timing of expirations. The
calculations get even more complicated when hedging calls and puts in order to maximize profit
and reduce potential losses.

A call option is a right given to a buyer and that is the right to purchase an underlying asset like
stocks or commodity futures contracts. When you look at a financial table that lists call options
you will discover multiple options with a variety of strike prices. The number of options reflects
the fact that the market never sleeps and prices of underlying instruments will regularly change.

It is not just strike prices that can vary either. The expiration dates will also vary. LEAPS options
are considered to be long term and expiration dates can be up to 3 years in the future. But many
call options have expiration dates stated in months.

Buying Call Options

When buying call options, you are said to go long, meaning you hope to buy an underlying
instrument at a profitable price compared to the strike price. You have until the option expiration
date to exercise the option. What you pay for the option is called a premium and the premium
goes to the option seller.

The long call can be profitable when the option is in the money. This means the strike price of
the underlying asset is less than the market price. For example, a stock option strike price is $25
and the market stock price rises to $28. The $3 is potential profit after including the premium and
transaction fees in the net profit calculation.

When the market price is higher than the strike price, you have several options. You can exercise
the call option and take ownership of the underlying asset whether its stock or a futures contract.
After exercising the long call, you now own an asset you can resell in the marketplace at the
higher market price. Since the market price is higher than what you paid for the underlying asset
after exercising the long call, you now have made a profit.

Another option you have when the option is in the money is to sell a call for the same underlying
asset with the same strike price and the same expiration date. The call option you sell will have a
higher premium value. You can continue to do this as long as the market prices are rising. It’s
easy to see how profitable call options can be in a bull market.

Selling Call Options

If you sell call options, it means you are selling a right to buy an underlying asset at a specific
strike price and by a specified exercise date. If the option expires, you earn the premium paid by
the buyer. If the buyer exercises the right, then you are obligated to sell the underlying asset.
Unfortunately, the only reason a buyer would exercise the option is because the market price of
the underlying asset is higher than the strike price

Selling a call option is called going short. When the market price of an asset rises above a strike
price, the option will be matched with an option buyer. The buyer is going to exercise the option
under these conditions. If the seller does not own the underlying asset, he or she will have to go
into the marketplace and pay the higher price to gain possession of the asset to sell to the buyer.

That is why they say there is theoretically unlimited loss risk when you go short. A covered
option is one where the seller owns the underlying asset supporting the option contract. This can
limit the amount of risk depending on what the market price is doing.

Call options offer much potential as profit makers as long as you understand how the
transactions work. It is important to first learn the terms and market operations before trading.
It’s simple advice that can earn you a lot of money while also limiting your risk of loss.

The Call Option…Getting Started

A call option is a particular type of option trade. When you read about options trading, the first
two terms you learn are often call and put. These are like the yin and yang of options investing.
A call lets you speculate that underlying asset prices are going to go up. The put lets you bet that
the prices of underlying assets are going to fall.

Many options traders begin their trading career in this type of investment by purchasing call
options. A call option gives you the right, but not the obligation, to buy or sell an underlying
futures contract or stock at a future date for a specified price. You “go long” when you have the
right to purchase. You “go short” when you have an obligation to sell.

When a call option is exercised, the seller of the option must give up control of the stock or
futures contract. If the call option is allowed to expire, the seller gets control of the underlying
asset back. So you can see that a call option is an actual contract between a buyer and seller and
there are specific terms in the contract.

Two of the key words in the definition of a call option are “right” and “obligation”. The call
option gives you a right to exercise the option, but you are under no obligation to do so. On the
other hand, the seller has an obligation to sell you the underlying asset if you decide to exercise
your right.

The Goal

The goal of an investor buying a call option is to make money on rising asset market prices. The
hope is that the price of the asset will rise and the option price will enable the buyer to purchase
the asset below market price. If the market price never reaches the strike price, then the option
can simply expire. The buyer loses the premium and the transactions costs but that is all.
That is another reason why beginning investors choose call options at first. The upside profit
potential is virtually unlimited. Of course, the strike price and the timing of the contract will
determine if the call option buyer is successful.

Naturally the seller hopes that the option stays out of the money. In that case the seller gets to
keep the underlying asset plus the premium and fees paid by the seller.

Call options can be purchased for stocks, bonds, agricultural commodities, precious metals,
interest rates and many others. Once the call option is in place, the seller cannot sell the
underlying asset included in the option terms to anyone else.

Watching the Market

Investors learning how to complete successful call option transactions can watch the market for a
period of time and witness how the big investors perform. When the market indicates large
volumes of call options during the day for a particular asset then you can probably assume the
investors expect the price to rise in the near future. The charts indicate expiration dates so you
can even see how soon the investors expect the prices to rise.

Call options naturally play a role in options strategies. For example, call options are used in long
and short straddles. A straddle is a trading strategy that is a spread. For example, a long straddle
balances a call option and a put option in a way that minimizes risk of loss while maximizing
speculation.

Preparing for Trading Options

People interested in trading options may be talking about trading stock options or trading options
on futures contracts. But the concepts underlying these types of financial trades are the same. An
option is simply a right, but not an obligation, to buy or sell some sort of financial product. The
financial product may be a stock or it may be a contract that has an underlying asset that is being
bought and sold in the marketplace. The future contract itself is an obligation that is placed on
the buyer and the seller like any other contract, but when trading options on futures contracts you
are talking about the buying and selling of the futures contract and not the commodity.

When comparing stock options to options on futures contracts, there are some similarities and
there are some differences. A stock option represents a contract to buy 100 shares of stock that
serves as the underlying instrument. An option on a futures contract represents one futures
contract that also gets its value from the price of the underlying instrument which are non-equity
assets like commodities.

Options for both stocks and futures contracts must outline the specifics of the transaction which
includes naming the underlying commodity or equity, delivery and price among others. Both
types of options also have calls and puts which indicate the equivalent of bets on whether the
price of the underlying asset will rise or fall. A call option means you expect the price to go up.
A put option means you expect the price to go down.
Both types of options also have a premium attached. The futures contract itself does not have a
premium, but the options on the futures contract does. The term premium refers to an amount a
buyer pays a seller for gaining the privilege of not having to buy the underlying asset in the event
the price movements are not beneficial to the buyer. It is the most a buyer can lose on a contract
no matter what the price of the asset does in the marketplace because the buyer can choose to not
exercise the right on a losing transaction.

Learning About Volatility

The amount of volatility in options refers to price action. Volatility addresses the propensity of
the price of the underlying security to go up or down in the marketplace. In a nutshell, there is a
relationship between the market conditions that affect the volatility of an asset and the volatility
of the option itself but that relationship may not be an exact correlation.

Estimating the possible price swings over the life of an option is one of the most complex
calculations in options trading. There is software available that can simplify the process, but
investors need to understand the concept of volatility. The desirability of volatility depends on
your option position. For example, if you are long in the option then volatility is a benefit for
both put and call options.

The more volatility there is in the marketplace, the more likely the option will be in the money.
That is why more volatility leads to higher premiums.

Two measures used to determine the relationship between the price of the option and the price of
the underlying asset are delta and theta. The terms are called Greeks.

• Delta – a formula to measure the relationship between a change in an option’s price and a
change in the price of the underlying asset of the futures contract. Delta represents the
percentage rate of change between prices. Values can range from -100 to 0 of talking
about put options. Delta values range from 0 to 100 if talking about calls. Sometimes the
delta ranges are expressed in decimal form.
• Theta – a formula that measures time decay. Time decay is the rate of change in the time
premium. The time premium is the value to the option price due to the remaining time
before contract expiration. Theta values increase from zero. The higher the Theta
measure the more volatility exists due to time decay.

There are many option pricing models including the Black-Scholes and Cox-Ross-Rubinstein
models. You don’t have to complete the calculations yourself but you do need to understand the
potential impact of volatility in the buying of stock options and options on futures contracts.

Factors that Affect Option’s Value

The following factors affect the value of an option:

• Spot price of the underlying asset

 • Strike price of the option
• Time to the expiration date of the option
• Risk-free interest rate
• Volatility of the underlying asset
• Option Pricing Model

The following option pricing models are often used to evaluate the fair value of the options:

• The Binomial model

• The black & Scholes model

Option Valuation
The competitive bids and offers in the marketplace affect the option premium. The price of an
option is a function of supply and demand. Stronger demand will drive the option price up.

An option premium is made up of two separate components:

• Intrinsic value: Intrinsic value of an option is based on the difference between its
exercise price and the current price of the underlying asset. Intrinsic value is part of the
premium which could be realized if the option were exercised. A put option has an
intrinsic value only if the asset price is above the exercise price. A put option has an
intrinsic value only if the asset price is below the exercise price.
• Time value: Time value represents the value placed on the possibility that the option may
become profitable to exercise at some time before the expiry date. The entire premium of
at-the-money options and out-of-the-money options represent time value. In-the-money
options have time value in addition to intrinsic value. Time value declines over time as an
option nears expiry. Expired option has zero time value. Hence the longer the time until
the expiration date, the higher an option’s time value premium.

Factors that Affect the Value of an Option

The following factors affect the time value of an option:

Price of the Underlying Asset

The price of the underlying asset is the most important factor in determining the option premium.

Exercise Price of the Option

The premium for an option which is deeply out-of-the-money will be less than an option which is
slightly out-of-the-money.

Time to Expiry
All other thing beings equal, the greater the time to the expiry date, the higher the time value of
the option. Expired option has zero time value.

Market Volatility

The volatility of the underlying asset plays an important role in the valuation of an option. In
general, the more volatile the market, the higher will be the premiums for option in that market.

Interest Rates

If there is a high cost of holding the asset due to high interest rates, there will be more demand
for call options on that asset. This is because the purchase of an call option involves a far smaller
cash outlay than buying the asset outright.

Cash Dividends

Any monetary return earned by holding the underlying asset will have effect on the price of an
option. For example, dividends of an equity stock.

Key Elements of an Option

There are five key elements of an exchange-traded option contract:

1. Types of Options

An option can be a call option or a put option.

A call option gives the option buyer the right to buy a specified asset at a specified price at or
before a specified date. The option seller is obliged to sell the underlying asset to the option
buyer if the buyer decides to exercise this right.

A put option gives the option buyer the right to sell a specified asset at a specified price at or
before a specified date. The option seller is obliged to buy the underlying asset to the option
buyer if the buyer decides to exercise this right.

2. Underlying Asset of an Option

An underlying asset of an option contract can be

• an asset (such as s specific stock) or

• an index or
• a particular futures contract or
• a debt instrument or
• a foreign currency or
• a commodity (such as gold)
3. Strike Price or Exercise Price of an Option

The strike price is also called the exercise price. It is the agreed price at which the underlying
asset will be traded if the option is exercised.

A call option is in-the-money if the price of the underlying asset is higher than the strike price
A call option is out-of-the-money if the price of the underlying asset is lower than the strike
price

A put option is in-the-money if the price of the underlying asset is lower than the strike price
A put option is out-of-the-money if the price of the underlying asset is higher than the strike
price

4. Expiry Date and Exercise Style of an Option

The expiry date of an option is also known as maturity date or exercise date or the declaration of
an option. It is the last day on which the option may be exercised.

An option can either be:

American style: Option can be exercised by the buyer at any time from the date of purchase up
until (and including) expiry date.

European style: Option can be exercised by the buyer only on the specified expiry date.

5. Option Premium

Option premium is the cost or price of the option. It is the amount paid by the buyer of an option
to the seller of an option.

Types of Options
Options have been there for more than a century. Options on equity stocks were available on the
London Stock Exchange more than a century ago. Chicago Board Options Exchange (CBOE)
was the first formalized options market that offered exchange-traded options on US listed equity
stocks. It was established in 1973. Since then, several stock exchanges, such as Australia Stock
Exchange, emulated the CBOE market and offered exchange-traded options market on equity
stocks. There exists a great diversity of exchange-traded options markets on equities, currencies,
debt instruments, stock index instruments.

There are two types of options:

• Exchange-traded options
• Over-the-counter options
The differences between these two types of options are listed in the table below:

Exchange-traded options (ET Over-the-counter options (OTC Options)

options)
Options that are originated and traded OTC options are not traded at a centralized
on a formalized exchanged market place or through a formalized trading
system.
Most commonly traded ET options are OTC markets exist in commodities, equities,
equity options and futures options stock indices, debt instruments and foreign
exchange.
ET transactions are settled through a There is no clearing house.
clearing house, associated with the
exchange.
ET options are floor traded on a OTC options are traded through face-to-face
physical floor or traded on a screen- meetings or over the telephone.
based trading system.
ET options are highly standardized as OTC options are tailor-made option
to the type and maturity of the agreements between two or more parties. The
underlying instrument. contracts are not standardized.

Basic Option Strategies

The four basic strategies of options are:

• Long call
• Long put
• Short call
• Short put

Calls and Puts Diagrams

Call Options and Put Options Diagram

How do we use them and how can they be replicated synthetically?

Long Call

The long call is one of the most simple and popular basic strategies for options. Long call is a
bullish strategy since it involves in buying a call option in the expectation that price will rise.

A long call can be replicated synthetically by a long underlying asset transaction and a long put
option.

As time passes, the value of a long call option erodes toward expiration value. If the volatility
increases, erosion slows. Conversely, as volatility decreases, erosion speeds up.

Long Put

If the trader expects the market is on the fall, he will make profit by buying a put option. As the
market falls, the profit of the put option increases.

A long put can be replicated synthetically by a short underlying asset transaction and a long call
option.

Short Call
A short call is the opposite position to the long call. The seller sells the option because he
believes the market is going down.

A long call can be replicated synthetically by a short underlying asset transaction and a short put
option.

Short Put

A short put is implemented by traders who believe that market is going up. It is the opposite
position of people who is bearish about the market.

A short put can be replicated synthetically by a long underlying asset transaction and a short call
option.

Natural Vs Synthetic Strategies

Natural Strategy Synthetic Strategy

Long Call = Long underlying and long put
Long Put = Short underlying and long call
Short Call = Short underlying and short put
Short Put = Long underlying and short call
Long underlying = Long call and short put
Short underlying = Short call and long put

Pay-off Diagrams for Option

Pay-off diagrams can be used as a means of illustrating the risk/return profile of an option
position. Pay-off diagrams allow you to visualize any trading strategy in a static form.

The x-axis (horizontal line) of a pay-off diagram represents the price of the underlying asset
The y-axis (vertical line) of a pay-off diagram represents the profit/loss on the option position.

Pay-off Diagrams for Options

There are four basic pay-off diagrams for options:

The Option Buyer

1. Long Call
Pay-off diagram below represents the effective pay-off of a long call position of an option at the
time of the expiry date. It looks at the option from the point of view of buyer.

Pay-off Diagram for Long Call Options

If a trader believes the share of a company is on the rise, he can purchase a call option without
buying the share. Assume he bought a call option (strike price is $5 and premium is 50 cent). The
break even point for this trade is $5.50. If at expiry date, the underlying share is trading at a point
between $5 and $5.50, he will be able to recover portion of the premium by exercising the
option. If the share is above $5.50 at this time, there will be a linear relationship between the
share price and the profit. If the share price has moved up to $6 by the option expiry date, the
profit on the option will be $0.50 (the different between the exercise price, which is $5, and the
current share price, less the option premium, which is $0.50)

2. Long Put

Pay-off diagram below represents the effective pay-off of a long put position of an option at the
time of the expiry date. It looks at the option from the point of view of buyer.
Pay-off Diagram for Long Put Position

If a trader believes the share of a company is on the decline, he can make money by buying put
options. Assume he bought a long option (strike price is $5 and premium is 50 cent). Two week
later, the share price falls to $4.5. The put option now has intrinsic value of $0.50. It will also
have a time value, likely to be $0.30. The option can now be sold in the marketplace for a
premium value of $0.80. The profit would be $0.30.

If at expiry date, the underlying share is traded at or above $5, there will be a loss of the full
premium. The break even point for this option is $4.50, which is equal to the strike price minus
the premium. If the share is trading below $4.50 by option expiry date, the option buyer would
make a profit. There will be a linear relationship between the share price and the option profit.

The Option Seller

3. Short Call

Option seller has limited profit potential and potentially unlimited risk. Pay-off diagram below
represents the effective pay-off of a short call position of an option at the time of the expiry date.
It looks at the option from the point of view of seller.

Diagram below shows a call option with a premium of 50 points. This position is the reverse of
the buyer’s. If the share price is below $5 at the expiry date, the seller will earn the full premium
50 point, which is $0.50. This is the most he can earn. The break even point for this option is the
same as the buyer, which is $5.50. At this price, the premium earned will be exactly offset by the
losses on the option position. If the share price moves above $5.50, the option seller’s loss moves
in a linear relationship with the share price. At $6, the option seller’s loss will be $0.50 (made up
of $1 loss on the option position less the premium earned of $0.50).
Pay-off Diagram for Short Call Position

4. Short Put

Pay-off diagram below shows the effective pay-off of a short put position of an option at the time
of the expiry date. It looks at the option from the point of view of seller.

Pay-off Diagram for Short Put Position

In this example, the seller will receive full premium if the share price is at or above $5 strike
price. However if the share price drops, there is a linear relationship between the index and the
loss made on this position. The break even point is $4.50, where the profit is equal to the loss
incurred.
Pay-off Diagrams for the Underlying

Example 1: Long Stock:

Pay-off diagram below represents the pay-off of a long position in the cash market. Assume you
purchase an ABC Co. share at $5. You are long stock. If the price of the stock remains at $5,
there is no profit or loss. If the price increases to $5.25, you earn $0.25 in profit. However if the
price drops to $4.75, your loss will be $0.25.

Pay-off Diagram for Long Stock

Example 2: Short Stock:

Pay-off diagram below represents the pay-off of a short position in the cash market. Assume you
purchase an ABC Co. share at $5. You are now short the market. If the price of the stock drops
to $4.75, you earn a profit of $0.25. However, if the price of the stock rises to $5.25, you make a
loss of $0.25.
Pay-off Diagram for Short Stock

Option Strategies – Spreads

Spreads are often used when the market is mildly bullish or mildly bearish. Trader who uses this
strategy expects the price of the underlying asset will move in a particular direction but is
unlikely to move very far. The profit and loss of spreads are limited.

There are two types of spreads:

• The bull spread

• The bear spread

Bull Call Spread

A bull call spread is made up of a long call and a short call.

The following diagram shows a bull call spread that is consist of a short 550 call with 25 points
premium and a long 450 call with 75 points premium.
Pay-off Diagram for Bull Call Spread

Maximum Profit Maximum Loss Break Even at Expiry

Difference in strike price less Difference in Lower strike price plus
difference in premium premium difference in premium

(550-450) – (75-25) 75-25 450 + (75-25)

= 100 – 50 = 50 = 450 + 50

= 50 = 500

As shown in the diagram, the profit and loss are limited. The break-even point is $5 and the
maximum profit on the bull call position is 50 point, which is $0.50. On the other hand, the
losses are limited to a maximum of 50 point, which is $0.50.

Bull Put Spread

A bull put spread consists of a short put and a long put.

The following diagram shows a bull put spread that is consist of a short 450 put with 25 points
premium and a long 550 put with 75 points premium.
Pay-off Diagram for Bull Put Spread

Maximum Profit Maximum Loss Break Even at Expiry

Difference in Difference in strike price less Higher strike price less
premium difference in premium difference in premium

75-25 (550-450) – (75-25) 550 – (75-25)

= 50 = 100 – 50 = 550 – 50

= 50 = 500

Bear Call Spread

Bear spread is the opposite of the bull spread position. High strike price is bough and the lower
strike price is sold.

A bear call spread is made up of a short call and a long call.

The following diagram shows a bear call spread that is consist of a short 450 call option with 75
points premium and a long 550 call with 25 points premium.
Pay-off Diagram for Bear Call Spread

Maximum Profit Maximum Loss Break Even at Expiry

Difference in Difference in strike price less Lower strike price plus
premium difference in premium difference in premium

75-25 (550-450) – (75-25) 450 + (75-25)

= 50 = 100 – 50 = 450 + 50

= 50 = 500

Bear Put Spread

A bear put spread is made up of a short put and a long put.

The following diagram shows a bear put spread that is consist of a short 450 put option with 25
points premium and a long 550 put with 75 points premium.
Pay-off Diagram for Bear Put Spread

Maximum Profit Maximum Loss Break Even at Expiry

Difference in strike price less Difference in Higher strike price plus
difference in premium premium difference in premium

(550-450) – (75-25) 75-25 550 – (75-25)

= 100 – 50 = 50 = 550 – 50

= 50 = 500

Option Strategies – Strangles

A strangle is the variation of the option straddle. The strangles involves buying (or selling) an
out-of-the-money call and an out-of-the-money put whereas the straddle involves buying (or
selling) an at-the-money call and an at-the-money put.

Long Strangle

The following diagram shows a long strangle in which out-of-the-money calls and puts are
bought. This strategy works best if the strike prices of the two options are close to equidistant
from the current market price. The advantage of long strangle over long straddle is that the
maximum loss is less. This is due to the fact that out-of-money options are cheaper to purchase.
The disadvantage is that the price of the underlying asset must move further than it does under a
straddle before a strangle position is profitable. The strangle is subject to the decay of time
premiums. The sooner the price of the underlying asset moves after the long strangle is in
position, the more like it is to be profitable.

Pay-off Diagram for Long Strangle

The call and put need not be bought at the same premium. The maximum lose is equal to the sum
of two premiums.

Short Strangle

Short strangle is the opposite position to the long strangle. This strategy makes money if the
market stagnates. However the potential loss can be unlimited.

The diagram below shows a short strangle, which is consist of selling an out-of-money put
option and an out-of-money call option. Like the short straddle, if the price of the underlying
asset suddenly moves up or down dramatically, the losses are theoretically unlimited. However,
the price must move further than it does under a short straddle before losses are made. The trade-
off is that the maximum profit of a short strangle is less than a short straddle.
Pay-off Diagram for Short Strangle

Option Strategies – Straddles

Straddles are often used when there is the expectation of a substantial rise or fall in the market.
Straddles are popular trading strategy in highly volatile markets.

Long Straddle

A long straddle is made up of a long call and a long put. This strategy is best entered into when
you expect the market to move buy are unsure which way it will do so. The potential loss of
using straddle is limited to the sum of the two premiums. However, the potential profit is open-
ended in either direction.

A long straddle can be replicated synthetically by:

• A long put option and long underlying asset transaction (which represents a long call)
• A long call option and short underlying asset transaction (which represents a long put)

Example:

Below is an example of a long straddle. It is made up of a long 500 put and a long 500 call, both
with the same strike price ($5.00) and the expiry date (April). In this case, both being at-the-
money, they are also trading at close to the same premium ($0.50, or 50 points)
Pay-off Diagram for Long Straddle

The following table shows the profit of a long straddle position.

Stock Long 500 Call (premium Long 500 Put (premium Long
Price 50) 50) Straddle
350 -50 +100 +50
400 -50 +50 0
450 -50 0 -50
500 -50 -50 -100
550 0 -50 -50
600 +50 -50 0
650 +100 -50 +50

At the expiration date, this strategy is only profitable when the share price has made a large
move either up or down. It must be above $6 or below $4 for a profit to be made on the option
position.

Short Straddle

The opposite of long straddle position is a short straddle. A short straddle is made up of a short
call and a short put with the same strike price. This position would be taken by a trader who
expects the market to stagnate. The maximum profit is the sum of the two premiums. The loss is
potentially unlimited in either direction.
A short straddle can be replicated synthetically by:

• A short put option and short underlying asset transaction (which represents a short call)
• short call option and long underlying asset transaction (which represents a short put)

Example:

Below is an example of a short straddle. It is made up of a short 500 put and a short 500 call,
both with the same strike price ($5.00) and the expiry date (April). This involves selling both the
500 put and the 500 call in the expectation that the share price will not move substantially from
its present level. The short straddle allows option seller to earn time premiums from the two
options as these premiums decay. The maximum profit will be earned if the market is at, or close
to, the strike price of the two options at the expiration date. If the share price moves substantially
from its current level of $5, it will incur loss. The loss can be unlimited.

Pay-off Diagram for Short Straddle