Buying Live Cattle Call Options to Profit from a Rise in Live Cattle Prices

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Contents

Buying Live Cattle Call Options to Profit from a Rise in Live Cattle Prices

If you are bullish on live cattle, you can profit from a rise in live cattle price by buying (going long) live cattle call options.

Example: Long Live Cattle Call Option

You observed that the near-month CME Live Cattle futures contract is trading at the price of USD 0.8445 per pound. A CME Live Cattle call option with the same expiration month and a nearby strike price of USD 0.8400 is being priced at USD 0.0600/lb. Since each underlying CME Live Cattle futures contract represents 40000 pounds of live cattle, the premium you need to pay to own the call option is USD 2,400.

Assuming that by option expiration day, the price of the underlying live cattle futures has risen by 15% and is now trading at USD 0.9712 per pound. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying live cattle futures at the strike price of USD 0.8400. This means that you get to buy the underlying live cattle at only USD 0.8400/lb on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying live cattle futures at the market price of USD 0.9712 per pound, resulting in a gain of USD 0.1312/lb. Since each CME Live Cattle call option covers 40000 pounds of live cattle, gain from the long call position is USD 5,248. Deducting the initial premium of USD 2,400 you paid to buy the call option, your net profit from the long call strategy will come to USD 2,848.

Long Live Cattle Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (USD 0.9712/lb – USD 0.8400/lb) x 40000 lb
= USD 5,248
Investment = Initial Premium Paid
= USD 2,400
Net Profit = Gain from Option Exercise – Investment
= USD 5,248 – USD 2,400
= USD 2,848
Return on Investment = 119%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the live cattle option sale will be equal to it’s intrinsic value.

Learn More About Live Cattle Futures & Options Trading

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

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Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Live Cattle Options Explained

Live Cattle options are option contracts in which the underlying asset is a live cattle futures contract.

The holder of a live cattle option possesses the right (but not the obligation) to assume a long position (in the case of a call option) or a short position (in the case of a put option) in the underlying live cattle futures at the strike price.

This right will cease to exist when the option expire after market close on expiration date.

Live Cattle Option Exchanges

Live Cattle option contracts are available for trading at Chicago Mercantile Exchange (CME).

CME Live Cattle option prices are quoted in dollars and cents per pound and their underlying futures are traded in lots of 40000 pounds (18 metric tons) of live cattle.

Exchange & Product Name Underlying Contract Size Exercise Style Option Price Quotes
CME Live Cattle Options 40000 lb
(Full Contract Specs)
American N.A.

Call and Put Options

Options are divided into two classes – calls and puts. Live Cattle call options are purchased by traders who are bullish about live cattle prices. Traders who believe that live cattle prices will fall can buy live cattle put options instead.

Buying calls or puts is not the only way to trade options. Option selling is a popular strategy used by many professional option traders. More complex option trading strategies, also known as spreads, can also be constructed by simultaneously buying and selling options.

Live Cattle Options vs. Live Cattle Futures

Additional Leverage

Limit Potential Losses

As live cattle options only grant the right but not the obligation to assume the underlying live cattle futures position, potential losses are limited to only the premium paid to purchase the option.

Flexibility

Using options alone, or in combination with futures, a wide range of strategies can be implemented to cater to specific risk profile, investment time horizon, cost consideration and outlook on underlying volatility.

Time Decay

Options have a limited lifespan and are subjected to the effects of time decay. The value of a live cattle option, specifically the time value, gets eroded away as time passes. However, since trading is a zero sum game, time decay can be turned into an ally if one choose to be a seller of options instead of buying them.

Learn More About Live Cattle Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying Call Options: The Benefits & Downsides Of This Bullish Trading Strategy

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Last Updated on June 24, 2020

Buying call options is a bullish strategy using leverage and is a risk-defined alternative to buying stock. Foregoing the abstract “call options give the buyer the right but not the obligation to call away stock”, a practical illustration will be given:

  1. A trader is very bullish on a particular stock trading at $50.
  2. The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
  3. The trader expects the stock to move above $53.10 in the next 30 days.

Given those expectations, the trader selects the $52.50 call option strike price which is trading for $0.60. For this example, the trader will buy only 1 option contract (Note: 1 contract is for 100 shares) so the total cost will be $60 ($0.60 x 100 shares/contract). The graph below of this hypothetical stock is given below:

There are numerous reasons to be bullish: the price chart shows very bullish action (stock is moving upwards); the trader might have used other indicators like MACD (see: MACD), Stochastics (see: Stochastics) or any other technical or fundamental reason for being bullish on the stock.

Options Offer Defined Risk

When a call option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in this example, $60. Whether the stock falls to $5 or $50 a share, the call option holder will only lose the amount they paid for the option. This is the risk-defined benefit often discussed about as a reason to trade options.

Options offer Leverage

The other benefit is leverage. When a stock price is above its breakeven point (in this example, $53.10) the option contract at expiration acts exactly like stock. To illustrate, if a 100 shares of stock moves $1, then the trader would profit $100 ($1 x $100). Likewise, above $53.10, the options breakeven point, if the stock moved $1, then the option contract would move $1, thus making $100 ($1 x $100) as well. Remember, to buy the stock, the trader would have had to put up $5,000 ($50/share x 100 shares). The trader in this example, only paid $60 for the call option.

Options require Timing

The important part about selecting an option and option strike price, is the trader’s exact expectations for the future. If the trader expects the stock to move higher, but only $1 higher, then buying the $52.50 strike price would be foolish. This is because at expiration, if the stock price is anywhere below $52.50, whether it be $20 or $52.49, the call option will expire worthless. If a trader was correct on their prediction that the stock would move higher by $1, they would still have lost.

Likewise, if the stock moved to $53 the day after the call option expired, the trader still would have lost all their premium paid for the option. Simply stated, when buying options, you need to predict the correct direction of stock movement, the size of the stock movement, and the time period the stock movement will occur; this is more complicated then stock buying, when all a person is doing is predicting the correct direction of a stock move.

Call Options Profit, Loss, Breakeven

The following is the profit/loss graph at expiration for the call option in the example given on the previous page.

Break-even

The breakeven point is quite easy to calculate for a call option:

  • Breakeven Stock Price = Call Option Strike Price + Premium Paid

To illustrate, the trader purchased the $52.50 strike price call option for $0.60. Therefore, $52.50 + $0.60 = $53.10. The trader will breakeven, excluding commissions/slippage, if the stock reaches $53.10 by expiration.

Profit

To calculate profits or losses on a call option use the following simple formula:

  • Call Option Profit/Loss = Stock Price at Expiration – Breakeven Point

For every dollar the stock price rises once the $53.10 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock gains $5.00 to $55.00 by expiration, the owner of the the call option would make $1.90 per share ($55.00 stock price – $53.10 breakeven stock price). So total, the trader would have made $190 ($1.90 x 100 shares/contract).

Partial Loss

If the stock price increased by $2.75 to close at $52.75 by expiration, the option trader would lose money. For this example, the trader would have lost $0.35 per contract ($52.75 stock price – $53.10 breakeven stock price). Therefore, the hypothetical trader would have lost $35 (-$0.35 x 100 shares/contract).

To summarize, in this partial loss example, the option trader bought a call option because they thought that the stock was going to rise. The trader was right, the stock did rise by $2.75, however, the trader was not right enough. The stock needed to move higher by at least $3.10 to $53.10 to breakeven or make money.

Complete Loss

If the stock did not move higher than the strike price of the option contract by expiration, the option trader would lose their entire premium paid $0.60. Likewise, if the stock moved down, irrelavent by how much it moved downward, then the option trader would still lose the $0.60 paid for the option. In either of those two circumstances, the trader would have lost $60 (-$0.60 x 100 shares/contract).

Again, this is where the limited risk part of option buying comes in: the stock could have dropped 20 points, but the option contract owner would still only lose their premium paid, in this case $0.60.

Buying call options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page.

Downside of Buying Call Options

Take another look at the call option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $53.10 is.

Call Options need Big Moves to be Profitable

Putting percentages to the breakeven number, breakeven is a 6.2% move higher in only 30 days. That sized movement is possible, but highly unlikely in only 30 days. Plus, the stock has to move more than that 6.2% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of buying 100 shares outright and buying 1 call option contract ($52.50 strike price) will be given:

  • 100 shares: $50 x 100 shares = $5,000
  • 1 call option: $0.60 x 100 shares/contract = $60; keeps the rest ($4,940) in savings.

If the stock moves 2% in the next 30 days, the shareholder makes $100; the call option holder loses $60:

  • Shareholder: Gains $100 or 2%
  • Option Holder: Loses $60 or 1.2% of total capital

If the stock moves 5% in the following 30 days:

  • Shareholder: Gains $250 or 5%
  • Option Holder: Loses $60 or 1.2%

If the stock moves 8% over the next 30 days, the option holder finally begins to make money:

  • Shareholder: Gains $400 or 8%
  • Option Holder: Gains $90 or 1.8%

It’s fair to say, that buying these out-of-the money (OTM) call options and hoping for a larger than 6.2% move higher in the stock is going to result in numerous times when the trader’s call options will expire worthless. However, the benefit of buying call options to preserve capital does have merit.

Capital Preservation

Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Buying call options and continuing the prior examples, a trader is only risking a small 1.2% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss of 5% is easier to take for an option call holder than a shareholder:

  • Shareholder: Loses $250 or 5%
  • Option Holder: Loses $60 or 1.2%

For a catastrophic 20% loss things get much worse for the stockholder:

  • Shareholder: Loses $1,000 or 20%
  • Option Holder: Loses $60 or 1.2%

In the case of the 20% loss, the option holder can strike out for over 16 months and still not lose as much as the stockholder. Moreover, the stockholder now has to make over 25% on their stock purchases to bring their capital back to their previous $5,000 level.

Moral of the story

Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options have many variables. In summary, the three most important variables are:

  1. The direction the underlying stock will move.
  2. How much the stock will move.
  3. The time frame the stock will make its move.
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