Introduction
Our previous discussion explored the fundamentals of call options and how they grant you the right (but not the obligation) to buy aluminium at a predetermined price. Now, let’s dive deeper into decision-making: When should you exercise a call option, and when is it better to abandon it?
Options are vital tools in hedging and investment strategies, providing flexibility that futures contracts do not. They allow traders to manage risk while maintaining the possibility of benefiting from favourable price movements. Understanding when to act and when to step back can significantly impact profitability and risk management.
Breaking Down the Decision
Scenario 1: Imagine you purchased a call option with a strike price of $2,700. This means you have the right to buy aluminium at that price, regardless of what happens in the market. Now, let’s consider two possible outcomes.
Aluminium’s market price rises to $3,000 – would you exercise the call?
Absolutely! Since the market price is higher than your locked-in purchase price, you’d buy at $2,700 and immediately benefit from the higher market price. Your profit would be the difference between $3,000 and $2,700, minus the premium you initially paid for the option.
This scenario highlights the core advantage of a call option – it allows you to capitalise on rising prices while having a predefined risk (limited to the premium paid).
Scenario 2: Let’s now consider a different scenario. You hold a call option with a strike price of $2,700, but the market price of aluminium drops to $2,000 at the time of expiration. Should you exercise your right to buy aluminium at $2,700 when it’s only worth $2,000?
No way! Doing so would mean paying $700 more per unit than the market price.
Instead, you’d abandon the option and let it expire worthless. Your loss in this case is limited to the premium you initially paid for the call option.
This scenario showcases another important feature of options: they provide downside protection. Unlike futures contracts, where you are obligated to buy or sell at a specific price, options allow you to step back when the market is unfavourable.
The Core Advantage of Options
Unlike futures contracts, where traders are bound by their agreements, options allow for flexibility. If the market moves in your favour, you exercise the option. If the market moves against you, you simply walk away, having lost only the premium paid.
However, this raises an important question: Should traders always choose call options over futures contracts? While options provide flexibility, they come with a cost—the premium. Depending on market conditions and trading strategies, sometimes futures may be a better choice. This is a topic we will explore in more depth in future discussions!
Conclusion
Options offer traders and hedgers the power of choice. Whether you choose to exercise or abandon depends on market conditions, making options a valuable tool in managing risk and optimizing investment decisions. By understanding this flexibility, traders can make more informed and strategic decisions.
Stay tuned for our next discussion, where we’ll break down option pricing, premium costs, and strategic decision-making in hedging!