Risk and Reward Characteristics of Buying a Call Option

Here is the profit and loss potential at the expiration of a January 100 call which was initially purchased for $5. The call allows the holder to buy the future at 100, so it will generally not be exercised if the market is below 100. Three scenarios develop at expiration:

1. If the market is below 100 the call will probably not be exercised because the holder can buy the future at a lower price in the open market. The maximum loss is $5, which is the original purchase price of the option and is shown by the horizontal line when the future is below 100.

2. If the market is at 100 the call mayor may not be exercised since the owner can buy the future in the open market at 100. The loss is still $5 as in as in 1.

3. If the market is above 100 the call should, and probably will, be exercised because the holder will own the future at 100, which is below where the market is trading. Assume the market is trading at 10S. The call is exercised so the holder is long the future at 100 and can immediately sell the future at 105 for a profit of $5. However, the $5 profit is negated by the original purchase price of $5 so the holder will breakeven on the trade.

The call does not have the downside risk associated with buying the outright because the maximum loss is limited by $5. However, the call closely resembles the 45C. line and profit potential of an outright long position initiated at 105, if the market rises above 100. Breakeven for the option occurs when the market reaches 105, which is the same breakeven point if the future were purchased at 105.

The approximate profit and loss potential in the present, and at expiration of purchasing the January 100 call. The price of the call option is relatively insensitive to the price of the underlying future below the 80 price level. The price of the call option will change by approximately a to 1/2 point for every I-point change in the price of the underlying future between 80 and 100. After the 100 level the call option will move approximately 1/2 to 1 point for a corresponding I-point move in the underlying future. After 110 the call will move about the same amount as the future. As time passes the potential profit and loss line in the present will eventually move closer to the profit and loss line at expiration. The potential profit and loss line in the present is approximate and may vary greatly because it is a function of factors, such as the volatility of the future and time to expiration of the option.