Welcome to another blog of Hedging with Jorge, where we continue to simplify complex market concepts into simple, practical explanations. We will explore the world of call options, a tool that offers flexibility and protection in uncertain markets.

A call option is essentially the right to buy an asset at a predetermined price, the strike price, within a specific time frame. But this right comes at a cost, referred to as the premium.

Let’s explore how call options work for speculators and hedgers with an example from the aluminium market.

Call options for speculators

Speculators buy call options when they believe the market price will go higher. Suppose aluminium is currently priced at $2,700 and you purchase a call option with a strike price of $2,700 for June. If the price rises beyond this level, exercising your right to buy at $2,700 allows you to benefit from the market’s upward movement.

But what happens if the market price doesn’t rise?

You simply abandon the option and lose only the premium paid, not the full downside you would face if you had bought futures outright. This is the key advantage for speculators – limited loss potential.

Call options for hedgers

Now, for hedgers, the logic is the complete opposite. A hedger, for instance, an aluminium consumer, buys calls to protect against price increases. They may have already sold at fixed prices but have yet to lock in purchase prices. The hedger needs to go long and they can do so by either buying futures or call options.

Why buy a call and pay a premium when futures involve no such cost?

Because the hedger expects prices to drop. If the market price falls below the strike price, they can choose not to exercise the call and purchase aluminium at the lower market price, only losing the premium. This provides protection if prices rise, but also allows them to benefit from a price decrease, a flexibility that futures do not offer.

Key Takeaways

• Speculators buy calls expecting prices to rise, limiting their loss to the premium if they’re wrong.
  

• Hedgers buy calls not because they want to exercise them but to secure protection in case the market goes higher, while still hoping for lower prices.
  

• Calls help manage risk while offering the possibility of upside gain or downside advantage, depending on market movement and strategy.

Stay tuned for more insights with Jorge in the next blog!