Buying Zinc Call Options to Profit from a Rise in Zinc Prices

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Buying Zinc Call Options to Profit from a Rise in Zinc Prices

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

Example: Long Zinc Call Option

You observed that the near-month LME Zinc futures contract is trading at the price of USD 1,212 per tonne. A LME Zinc call option with the same expiration month and a nearby strike price of USD 1,200 is being priced at USD 80.80/ton. Since each underlying LME Zinc futures contract represents 25 tonnes of zinc, the premium you need to pay to own the call option is USD 2,020.

Assuming that by option expiration day, the price of the underlying zinc futures has risen by 15% and is now trading at USD 1,394 per tonne. 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 zinc futures at the strike price of USD 1,200. This means that you get to buy the underlying zinc at only USD 1,200/ton on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying zinc futures at the market price of USD 1,394 per tonne, resulting in a gain of USD 194.00/ton. Since each LME Zinc call option covers 25 tonnes of zinc, gain from the long call position is USD 4,850. Deducting the initial premium of USD 2,020 you paid to buy the call option, your net profit from the long call strategy will come to USD 2,830.

Long Zinc Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (USD 1,394/ton – USD 1,200/ton) x 25 ton
= USD 4,850
Investment = Initial Premium Paid
= USD 2,020
Net Profit = Gain from Option Exercise – Investment
= USD 4,850 – USD 2,020
= USD 2,830
Return on Investment = 140%

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 zinc option sale will be equal to it’s intrinsic value.

Learn More About Zinc Futures & Options Trading

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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.

Understanding How Options Are Priced

You might have had success beating the market by trading stocks using a disciplined process anticipating a nice move either up or down. Many traders have also gained the confidence to make money in the stock market by identifying one or two good stocks posed to make a big move soon. But if you don’t know how to take advantage of that movement, you might be left in the dust. If this sounds like you, maybe it’s time to consider using options. This article will explore some simple factors to consider if you plan to trade options to take advantage of stock movements.

Key Takeaways

  • Options contracts can be priced using mathematical models such as the Black-Scholes or Binomial pricing models.
  • An option’s price is made up of two distinct parts: its intrinsic value and its time (extrinsic) value.
  • Intrinsic value is based on an option’s in-the-moneyness and is relatively straightforward to compute.
  • Time value is based on the underlying asset’s expected volatility and time until the contract’s expiration and is far more complex to calculate.

Option Pricing

Before venturing into the world of trading options, investors should have a good understanding of the factors determining the value of an option. These include the current stock price, the intrinsic value, time to expiration or the time value, volatility, interest rates, and cash dividends paid.

There are several options pricing models that use these parameters to determine the fair market value of an option. Of these, the Black-Scholes model is the most widely known. In many ways, options are just like any other investment—you need to understand what determines their price to use them effectively. Other models are also commonly used such as the binomial model and trinomial model.

Let’s start with the primary drivers of the price of an option: current stock price, intrinsic value, time to expiration or time value, and volatility. The current stock price is fairly obvious. The movement of the price of the stock up or down has a direct, although not equal, effect on the price of the option. As the price of a stock rises, the more likely it is that the price of a call option will rise and the price of a put option will fall. If the stock price goes down, the reverse will most likely happen to the price of the calls and puts.

Understanding Option Pricing

Intrinsic Value

Intrinsic value is the value any given option would have if it were exercised today. Basically, the intrinsic value is the amount by which the strike price of an option is in the money. It is the portion of an option’s price not lost due to the passage of time. The following equations can be used to calculate the intrinsic value of a call or put option:

The intrinsic value of an option reflects the effective financial advantage resulting from the immediate exercise of that option. Basically, it is an option’s minimum value. Options trading at the money or out of the money, have no intrinsic value.

For example, let’s say General Electric (GE) stock is selling at $34.80. The GE 30 call option would have an intrinsic value of $4.80 ($34.80 – $30 = $4.80) because the option holder can exercise his option to buy GE shares at $30, then turn around and automatically sell them in the market for $34.80—a profit of $4.80.

In a different example, the GE 35 call option would have an intrinsic value of zero ($34.80 – $35 = -$0.20) because the intrinsic value cannot be negative. Intrinsic value also works the same way for a put option. For example, a GE 30 put option would have an intrinsic value of zero ($30 – $34.80 = -$4.80) because the intrinsic value cannot be negative. On the other hand, a GE 35 put option would have an intrinsic value of $0.20 ($35 – $34.80 = $0.20).

Time Value

The time value (or, extrinsic value) of options is the amount by which the price of an option exceeds the intrinsic value. It is directly related to how much time an option has until it expires, as well as the volatility of the stock. The formula for calculating the time value of an option is:

T i m e V a l u e = O p t i o n P r i c e − I n t r i n s i c V a l u e Time\ Value = Option\ Price-Intrinsic\ Value T i m e V a l u e = O p t i o n P r i c e − I n t r i n s i c V a l u e

The more time an option has until it expires, the greater the chance it will end up in the money. The time component of an option decays exponentially. The actual derivation of the time value of an option is a fairly complex equation. As a general rule, an option will lose one-third of its value during the first half of its life and two-thirds during the second half of its life. This is an important concept for securities investors because the closer you get to expiration, the more of a move in the underlying security is needed to impact the price of the option. Time value is often referred to as extrinsic value.

Time value is basically the risk premium the option seller requires to provide the option buyer the right to buy/sell the stock up to the date the option expires. It is like an insurance premium for the option; the higher the risk, the higher the cost to buy the option.

Looking again at the example from above, if GE is trading at $34.80 and the one-month-to-expiration GE 30 call option is trading at $5, the time value of the option is $0.20 ($5.00 – $4.80 = $0.20). Meanwhile, with GE trading at $34.80, a GE 30 call option trading at $6.85 with nine months to expiration has a time value of $2.05. ($6.85 – $4.80 = $2.05). Notice the intrinsic value is the same, the difference in the price of the same strike price option is the time value.

An option’s time value is also highly dependent on the volatility the market expects the stock to display up to expiration. For stocks not expected to move much, the option’s time value will be relatively low. The opposite is true for more volatile stocks or those with a high beta, due primarily to the uncertainty of the price of the stock before the option expires. In Figure 1 below, you can see the GE example already discussed. It shows the trading price of GE, several strike prices, and the intrinsic and time values for the call and put options.

General Electric is considered a stock with low volatility with a beta of 0.49 for this example.

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