Chapter 26: 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 92 call option would convey the right to buy one March U.S. Treasury bond futures con-tract at a price of $92,000 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 fu-tures price is above the option exercise price by more than the premium paid for the op-tion. Or a profit can be realized if, prior to expiration, the option rights can be sold for more than they cost.
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 90 call. Assume the premium you pay is $2,000.

If, at the expiration of the option (in May) the June T-bond futures price is 93, you can realize a gain of three (that’s $3,000) by exercising or selling the option that was purchased at 90. Since you paid $2,000 for the option, your net profit is $1,000 less transac-tion costs.

As mentioned, the most that an option buyer can lose is the option premium plus transac-tion costs. Thus, in the preceding example, the most you could have lost—no matter how wrong you might have been about the direc-tion and timing of interest rates and bond prices—would have been the $2,000 pre-mium you paid for the option plus transaction costs. 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 re-duced by the amount of the premium. In the example, the option buyer realized a net profit of $1,000. For someone with an outright long position in the June T-bond futures contract, an increase in the futures price from 90 to 93 would have yielded a net profit of $3,000 less transaction costs.

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 held until expira-tion is not worthwhile to exercise.