Hedging with Jorge #Episode 40: Understanding call options – When and how to exercise

Today, we’re diving into call options, what they are, how they work and the factors influencing whether you should exercise them. Let’s break it down using a simple example from the aluminium market.

A call option is a right to buy a commodity (in this case, aluminium) at a specified price (known as the strike price) on or before a specific date. It does not obligate you to buy; it only gives you the right to do so.

Let’s consider this scenario: You buy a call option for aluminium with a strike price of $2,700 per tonne, paying a premium of $90. This call expires in June. But what does that mean practically? It means that by the first Wednesday of June, you must decide whether to exercise your right to buy at $2,700 or let the option expire worthless.

If you choose to exercise, the call option transforms into a long futures position for the third Wednesday of June, at the strike price of $2,700. But before making that decision, you need to look at the futures price for that third Wednesday of June.

Exercising the option makes sense if the futures price is higher than your strike price of $2,700. For example, if the futures price is $2,800, exercising allows you to buy at $2,700 and immediately hold a position at a more favourable rate. This is a clear win.

However, if the futures price is below $2,700, you simply abandon the option. There’s no benefit in exercising your right to buy at a higher price than the market.

A common misunderstanding occurs when the market price is only slightly higher than the strike price. For instance, if the price on the first Wednesday of June is $2,710, some traders hesitate because the increase is just $10 and they pay a $90 premium. While this might feel like a loss, if the price is above $2,700, you should still exercise the option. The decision to exercise is not about recovering your premium but about taking advantage of favourable price conditions. The premium is part of the initial cost, and market moves won’t always cover it.

In conclusion, call options offer flexibility and an opportunity to profit when markets rise above your strike price. The key is to understand that you exercise the call whenever the futures price is higher than the strike price, regardless of the premium. It’s all about strategic decision-making based on real-time market data.

Stay tuned for more insights with Jorge!