Futures Options Trading | Call Options Explained in Plain English

Call Options Explained in Plain English

by Phil R.

Let me put a disclaimer out here from the start: Any attempt to have call options explained is not easy, and it normally takes a while (it took me at least a week) to fully grasp the concept of what a call option is, and what it represents. Options are an ever-evolving concept for me, and I’m pretty sure any active options trader will tell you the same thing. There are many different types of options out there, and each one would require its own website worth of information to grasp each individual concept. In addition, there’s a whole mathematical side of options trading that completely confuses the heck out of me (like how the Black and Scholes model works), and I don’t claim to understand the extremely complicated equations that explain option decay, option price movement, and so forth. I’m much more of a simple kind of guy, so I was always very appreciative whenever I found any kind of information on the Web that explained options in “layman’s terms”, so to speak. So I’m not going to delve into any deep theories about options pricing models or anything like that; I’m simply going to explain what a call option is from a very top-level, 30,000-foot-view type of perspective.

I have traded both commodity (or futures) and stock options, but for ease of explanation, I’ll just narrow it down to futures options. An option, whether it’s a call option or a put option, is a contract that basically gives you the right, but not the obligation, to buy one futures contract for a fixed price within a fixed time period. That already sounds a little convoluted…see, I told you that it may take a few days to sink in. Think about it this way…if you were at a department store and you wanted to buy a DVD player that was on sale, but then you found out that the last one was sold before you had a chance to get to it, most stores will allow you to create a raincheck for that item. Meaning, once they get the DVD player back in stock, even if it’s way after the sale is over, you still have the right to buy the DVD player at its sale price, because you basically “staked your claim” while the item was on sale. Now you’re not obligated to buy the DVD player even though you have a right to buy it; this is the same principle at work with call options. For example, if you bought a call option on Corn, you would now have the right (but not the obligation) to buy one Corn contract at a price that you choose (otherwise known as the “strike price”).

Call Options Explained

The whole point of buying call options is that you expect the price to rise in the relatively near future. So if Corn is trading at 460.00 (which it happens to be right now), you might want to buy a call option with a strike price of 460.00, and if the price of Corn does indeed rise, you are now making a profit on your call option. Somebody might ask “Well, if that’s the case, why not buy the Corn futures contract outright instead of just buying a call option?” There’s a big difference in price between one Corn futures contract and a call option representing one Corn futures contract. If you bought the contract outright, you’re looking at an initial margin outlay of roughly $2,000 (but it does fluctuate), but if you bought an option on that same Corn contract (and by the way, every option contract represents 1 futures contract), you would only be laying out a fraction of that price. For instance, as of this writing, with Corn trading at about 460.00, a call option with a 460.00 strike price (closest expiration month) is going for about $840.00 right now. Another HUGE benefit of buying call options is the fact that (unlike buying the futures contract) your risk is limited; with buying options, you can never lose more than your initial investment. If you were to buy a Corn contract outright and the market wildly moved against you (which happens more often than we are comfortable admitting), you could not only lose all of the money in your account, but be liable for whatever deficit is owed on the contract as well–this is known as a “margin call”, and if you’ve ever received one, they are no fun…I know this from experience.

So with our Corn call option example (460.00 strike price), $840.00 is the most you can lose, so you know your total risk level right off the bat. Once you buy the option, your risk is set, and you now have the right to buy one Corn contract stock at the 460.00 price level, no matter how high the actual futures price goes. If Corn were to have a major spike in price and shot up to 500.00, you still have the right to buy your Corn contract at 460.00. So, in this example, you would do what’s known as “exercising your option”, giving you the right to enter into a position where you purchase 1 Corn futures contract at 460.00, even though the market is currently trading at 500.00, meaning you have a 40 cent (remember, Corn’s futures price is denominated in cents per bushel) profit right off the bat. Multiply that times the point value of each cent, which would be $50, and you now are sitting nice and pretty with a $2,000 profit (40 cents x $50)! It’s a great way to manage the volatility of futures prices without seeing your trading account fluctuate up and down with the price movements, plus it greatly reduces your overall capital at risk.

Some people will do what’s known as buying “out-of-the-money” call options, meaning call options with strike prices that are well above the current market price. For example, if you were to buy a call option on Corn with a strike price of 490.00, even though Corn is currently trading at 460.00, it would be much less expensive, because “out-of-the-money” option prices (also known as “premiums”) are based on the probability of whether or not the futures contract will ever actually hit that price. So, buying a Corn call option with a 490.00 strike price (when Corn is currently trading at 460.00) will only be about $350.00–very cheap indeed. But if Corn were to have a dramatic and quick spike in price, and it jumped up to 500.00, your call option is now “in-the-money”, because Corn’s price is higher than your strike price, and you would be sitting with a pretty nice profit on your option. You don’t even have to exercise your option to make a profit on it; the options themselves will increase in value along with the futures contract’s increase in value. There are many cases where people have bought options for no more than $25.00 or $50.00, and they ended up being worth hundreds of dollars or more when dramatic price movements in the underlying futures contract happened.

Whoa, I just checked my word count on this post, and it’s ridiculous. I’m realizing even as I write this that there’s really not a “simple” way to explain options. Nonetheless, I hope this little diddy on call options explained has at least begun to bring some clarity to this detailed area of investing.

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