Buying options – some examples

Buying options – both calls and puts – is the simplest way to use options.

Buying a call

Buying a call option gives you the right to buy an asset on the expiry date.

This is a strategy that you would use if you were bullish about the prospects of the underlying asset, which means you believe its price will rise.

For example, imagine that an option on the FTSE 100 has a strike price of 6500. Let’s say that the option has a premium of 35. The expiry date is the third Friday in March.

There are several things that can happen by the point of expiry.

Let’s say that on expiry the price of the FTSE has risen from 6300 to 6453. The right to buy at 6500 is therefore worth nothing (it would cost more than buying the asset). You lose the premium paid.

If the expiry price has risen to 6500, the index has reached the strike price of the option, but there is still no point in paying anything for the right to buy at the current level of the market. You still lose all of the premium paid.

If the expiry has risen to 6530, say, the 6500 call would be worth 30 points – the right to buy at 6500 has to be valued at 30 – the difference between the option and the actual price.

However, this might not be enough of a difference to show a profit. You need to cover the cost of the premium.

If the expiry is at 6535, the 6500 call would be worth 35 points. This is enough to cover your premium – anything above it provides a real profit.

The value of the call at expiry:

As the graph shows, below 6500 equates to the maximum loss of 35 points ($350 if you bought one contract). 6535 is the breakeven level: the point at which the option is worth enough to make back the premium that it originally cost. The breakeven point is calculated by adding the premium to the strike price. In the example this is 35 + 6500 = 6535.

Risk
If you buy a call option, the risk is limited to the premium. In our example the premium was only a small fraction of the value of the underlying asset, so buying the option can be considered less risky than buying the asset itself.

Remember, that the whole premium is at risk and it can be easy to lose 100% of it.

Reward
The rewards are, in theory at least, unlimited when you buy a call option. The value of the call will increase with the value of the underlying asset, and the higher it goes, the greater the profits.

Remember you will have to deduct the premium of the call to calculate your profits.

Buying a put

Buying a put option gives you the right to sell an asset on the expiry date.

This is the strategy that you would use if you were bearish about the prospects of the underlying asset – you believed its price would fall.

For example, imagine again that the FTSE 100 is trading at 6500. Let’s say that you buy a 6150 put option for a premium of 50 points. This means you have the right to sell at 6150 on the expiry date.

There are again several things that can happen by the point of expiry.

Let’s say that the expiry price is 6030. The right to sell at 6150 must be worth 120 points. The option cost 50 points of premium, so that overall the profit is 120 – 50 = 70 points. If you traded one contract with a $10 lot size, this would mean a profit of $700 (70 x $10).

The breakeven point is 6100. Between 6100 and 6150 the option still has some value, which will be just enough to help recoup the premium paid. Above this, the option would be worthless. The loss would be the premium: 50 points. So if you’d bought one contract ($10 lot size) , the loss would be $10 x 50 = $500.

The value of the put at expiry:

The breakeven point and the maximum profit are calculated by subtracting the premium from the strike price. For our example, this is 6150 – 50 = 6100. In other words, the premium needs to be ‘recovered’ before the position starts making a profit, just as it does when you buy a call.

Unlike buying a call, however, the maximum profit is not unlimited. This is because the underlying asset cannot fall below zero. At this level, the asset could, theoretically, be bought for nothing and then sold at 6100. The maximum profit would be 6100 points less the 50 points of premium it cost to buy the put.

You might decide to close early
You may not want to wait until expiry. So, in this example, if the underlying moved from 6500 to 6300 a week after you traded, the chances are the put would be worth more than you paid for it, even though the underlying hadn’t got to your strike. You could close early and take a profit.

Risk
The risk is limited to the premium when buying a put, the same as when buying a call.

Reward
The value of the right to sell increases as the underlying price drops. You’d make the maximum profit if the underlying asset price fell to zero.

Basic Strategy	Risk (max. loss)	Reward (max. profit)
Buy call	Limited to premium	Unlimited
Buy put	Limited to premium	Almost unlimited – but the underlying price cannot fall below zero

Question

Question 1

If you buy a call the risk is:

a Unlimited
b Limited to the premium

Reveal answer

Question 2

If you buy a put you can close before expiry:

a True
b False