A derivative that provides you with leverage during rallies, while limiting your risk. Gold call options, for example, can magnify gains on the long position in gold. The catch is that you have to be right on time.
Eric, Jill and John are in front of Eric’s computer trying to figure out what movie they would like to buy via VOD. Eric comes up with a proposition of his own.
Call Options - Details
Call option is an agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period. He/she profits on a call when the underlying asset increases in price.
More specifically, call options can be divided into two types:
- Long call
- Short call.
In most cases these are non-delivery options, which means that an investor does not actually exercise their right to buy an asset at a specified price but rather settles for an appropriate cash amount. Still, in most cases, traders sell options before they expire (options that is). This will be explained on an example shortly.
An investor has a long call option on their hands when they buy an option agreement in which they are entitled to receive money when the price of an underlying asset exceeds a specified level, which level is called the strike price.
Call Options on Gold - Example
In a quick example, gold trades at $1,800. An investor buys a gold call option for $20 which allows them to cash in the positive difference between the price of gold and $2,000 in a year. If the price of gold declines instead of rallying and after one year is below $1,500 then the investor does not lose any money beyond what he has paid for the option - $20 in this case.
There are two possible scenarios. In the first one, after one year gold is below (or at $2,000). The investor does not receive any money and, all in all, they have lost $20 paid for the option itself. The second scenario is that the price of gold after one year exceeds $2,000. The investor exercises their right to receive money.
Depending on how much above $2,000 gold trades, the investor will end up with profit or loss. If gold is at $2,500, then the investor cashes in $500 ($2,500 - $2,000), but they still need to remember they have paid $20 for the gold call option. So, at the end of the day, they arrive at a profit of $480 ($500 - $20).
If after one year gold is at $2,010, then the investor receives a payoff of $10 ($2,010 - $2,000) but still needs to factor in the $20 they have spent on the option. They end up with a loss of $10 ($10 - $20 = -$10, which is a loss).
We have described the payoffs of a buyer of a call option. How about its issuer (or seller)? Such an issuer (usually an institution rather than an individual investor) is the party which has to pay money if the price of the underlying asset exceeds the agreed level (the strike price). They have a short call option on their hands.
In our example, if gold ends up at $2,500, the issuer has to pay our investor $500. However, the issuer already has received $20 for the option. So, the final result for the issuer is a loss of $480 (-$500 + $20 = -$480). To be precise, it would be a bit less than -$480, because the institution would likely earn interest on the $20 during the year. On the other hand, if gold winds up at $2,000 (or below), the issuer does not pay the investor anything and the end up with a profit equal the amount they received for the option – that is $20 (plus interest that they earned on that sum during the year).
Below, you will find a chart illustrating the possible payoffs of a long call option in our example.
The horizontal axis represents the price of gold, while the vertical axis represents the appropriate payoff of the buyer. As mentioned before, the buyer would break even with gold at $2,200.
Asymmetry of Risk
The interesting property of options is that the investor which holds a call option risks only with the amount they pay for the option (in our example it is $20). They have the right, but not the obligation to exercise the option. So, their downside is limited. However, their upside is not as there is no upper limit imposed on the price of gold (putting the manipulation theories aside for a moment).
The issuer of the option faces an inverse setting. They can gain only the amount they receive for the option (our $20) but they are obliged to pay any amount resulting from the price of the underlying asset at the end of the contract (so, if gold were at $5,000, they would still have to pay out $3,000). The upside potential here is limited while the downside is not.
The fact that the buyer can gain infinitely much (in theory of course) and lose only a specified amount while the issuer can gain only a limited amount of money and lose an unlimited one (once again, in theory) is called the payoff asymmetry (or asymmetric payoffs) which translates into an asymmetry in risk.
So why do even market players engage in short options if the downside is unlimited? The answer is that they set the option price at a level which they deem as high enough to offset the chance of ending up in the red. Plus they are certain to cash in option’s price right away, while the one that purchases the option only has a chance of making a profit in the future.
You Have to Be Right on Time
The main problem with being on the buying side in a call option deal is that the premium one pays (the price of an option) is usually considerable. What is more, to profit on a long call option one has to properly time their bet. A call option is a you-have-to-be-right-and-right-on-time kind of contract. The first part (being right) is quite straightforward: an investor speculating with a long call option anticipates the price to rise above the strike price. If the price goes in that direction and exceeds the strike price by more than the option premium (the price one pays for a call option), then they may profit from such a move (and gains can be truly spectacular). The second part is a little bit more complicated (being right on time): the anticipated price move (up) has to happen within the contract period. Note that the above-mentioned example said about gold moving to a given price in year. If gold moved to this price – but in two years, and it would do nothing during the first year – the option holder would lose everything, while those invested in gold could simply wait out the “bad” year.
There is more to it: once an investor is in a position to make profit on the option, they have to decide whether they want to realize their gains or they believe that the price of the underlying asset will go even higher. If they decide to wait for a further move up, such a move has to occur relatively quick or be of relatively high magnitude.
Why? The answer is that options have a property to lose value in time. If the investor has an option which entitles him to receive money, they can sell this option at profit. However, if they decide to wait and a further move up does not materialize, the option is likely to be worth less. This phenomenon is called time decay.
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