Index Options Strategies: Buying Index Calls - Part Two
...Continued from Part One
Scenario
Assume the underlying index that interests you is symbolized as XYZ and is currently at a level of 200. You decide to purchase a 6-month XYZ 205 call for a quoted price of $4.75 per contract. Your net cost for this call is $475 ($4.75 x 100 multiplier). You are risking $475 if the underlying index level is not above the strike price of 205 when the XYZ call expires.
The break-even point (BEP) at expiration is an XYZ index level of 209.75 (strike price 205 + premium paid $4.75) because the call will be worth its intrinsic value of $4.75, which is what you originally paid for it. The higher the XYZ index settlement value is above the break-even point at expiration, the greater your profit.
Possible Outcomes at Expiration
1. XYZ index level above the break-even point (209.75):
If at expiration XYZ index has advanced to 215, the XYZ 205 call will be worth its intrinsic value of $10 (settlement value 215 - strike price 205). Your net profit in this case would be $525 (settlement amount $1000 received from exercise - net cost of call $475).
| Buy XYZ Index 205 Call at $4.75 with Index at 200 Net Cost for Call = $475 | |||
|---|---|---|---|
| Level of XYZ Index at expiration | XYZ Index Declines to 198 (below strike) | XYZ Index Advances to 207 (between strike and BEP) | XYZ Index Advances to 215 (above BEP) |
| Move in level of index | down 2 pts. | up 7 pts. | up 15 pts. |
| Value of call at expiration (per contract) | 0 (out-of-the-money) | $2 | $10 |
| Less premium paid for call | $4.75 | $4.75 | $4.75 |
| Net profit/loss* (per contract x 100) | ñ$475 | ñ$275 | $525 |
*Exclusive of commissions, transaction costs and taxes.
2. XYZ index level between strike price (205) and break-even point (209.75):
If at expiration XYZ index has advanced to 207, the XYZ 205 call will be worth its intrinsic value of $2.00 (settlement value 207 - strike price 205). You could exercise the option and receive the settlement amount of $200 ($2.00 intrinsic value x 100 multiplier).
This amount would be less than the net amount paid for the call ($475), but it would offset some of that cost. The net loss in this case would be $275 (net cost of call $475 - settlement amount $200 received from exercise). This loss represents a little more than half of your initial investment.
3. XYZ index level below strike price (205):
If at expiration XYZ index has declined to 198, the call would have no value because it is out-of-the-money. You will have lost all of your initial investment, a net of $475. The net premium paid for an index option represents the maximum loss for an option purchaser.
Note: No matter how far XYZ declines below the strike price, the loss will not exceed $475.
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