In this lecture we’ll look at how a company might use the purchase of a call option to make sure their business costs remain at an acceptable level.

Suppose a company, let’s call them ABC, is building a facility for a new project. The new facility needs oil for one of its industrial processes, but the facility itself and the building that will be used to store the oil is not completed yet.

The profitability of the project will partially depend on how much they have to pay for the oil. The problem ABC has, is they are not ready to purchase the oil yet and won’t be until the 20th of June next year.

The current price of oil is $40 a barrel. At this price the project is expected to make a nice profit, and indeed it will continue to make an acceptable profit as long as the price of oil remains under $60 a barrel. However, the project becomes much less economically attractive if they have to pay more than $60 a barrel for the oil.

What ABC would really love is a way to guarantee that they don’t have to pay more than $60 a barrel for the oil in June when they are ready to make the purchase. This could take the form of a legal agreement with another company that has oil to sell, let’s call this other company XYZ, that agrees to sell ABC the oil at no more than $55 per barrel on the 20th of June next year. That is, even if the price of oil increases to more than $55 per barrel, XYZ will be obligated to sell ABC oil at $55 per barrel.

What’s in it for XYZ you may ask? Well, in exchange for this valuable agreement, ABC pays a fee (or premium) to XYZ. The fee could be something like $2 per barrel. This $2 per barrel fee is kept by XYZ no matter what happens.

This agreement between ABC and XYZ is essentially a call option. ABC has paid a fee to XYZ, and in exchange XYZ has given ABC the option to buy oil at $55 per barrel on June 20th.

In the previous lecture we listed the 5 main parameters of an option contract:

  • The underlying asset
  • The option type
  • The expiry date
  • The strike price
  • The option price

In this example, the underlying asset is oil. The option type is a call option, which you may remember is the right to buy the asset. The expiry date is June 20th next year. The strike price is $55. And the option price is $2 per barrel.

ABC has used the call option as a kind of insurance against the price of oil increasing in future. This is valuable to them because the price of oil could potentially increase to a point that makes their project unprofitable. If the price of oil increases before they are ready to purchase it on June 20th, their project may no longer be very attractive, or even profitable at all. By purchasing the call option they guarantee themselves the option of buying oil at a price that makes their project profitable.

Let’s take a look at what effect buying this call option will have for ABC, based on three different prices of oil on June 20th next year.

Scenario 1:
The price of oil has decreased to $20/barrel on June 20th. ABC is now ready to purchase the oil. The call option gives them the option to buy oil at the strike price of $55 per barrel. Because it’s possible to purchase the oil at $20 in the open market though, there is no point using the option to purchase it at $55 from XYX.

ABC therefore purchases the oil they need at $20 per barrel in the open market. They also paid $2 per barrel for the call option though, so their total cost is $22. This is $2 more expensive than if they had not purchased the call option, but is still well below the $60 threshold that makes the project viable. So in scenario 1, where the price of oil has decreased, ABC’s project is profitable.

Scenario 2:
The price of oil remains unchanged at $40/barrel on June 20th. ABC is now ready to purchase the oil. The call option gives them the option to buy oil at the strike price of $55 per barrel. Because it’s possible to purchase the oil at $40 in the open market though, there is no point using the option to purchase it at $55 from XYZ.

ABC therefore purchases the oil they need at $40 per barrel in the open market. They also paid $2 per barrel for the call option though, so their total cost is $42. This is $2 more expensive than if they had not purchased the call option, but is still well below the $60 threshold that makes the project viable. So in scenario 2, where the price of oil has not changed, ABC’s project is profitable.

Scenario 3:
The price of oil has increased to $100/barrel on June 20th. ABC is now ready to purchase the oil. The call option gives them the option to buy oil at the strike price of $55 per barrel. Because the price of oil is now $100/barrel in the open market, it is much more preferable for them to use the option to purchase it at $55 from XYZ.

ABC therefore exercises the call option with a strike price of $55, which means they only pay $55 per barrel for the oil they need. They also paid $2 per barrel for the call option though, so their total cost is $57. Although the price of oil has increased dramatically, the call option has kept the total cost limited to $57. As this is still below the $60 threshold, the project is still viable. So in scenario 3, where the price of oil has increased dramatically, ABC’s project is still profitable.

Notice in this final scenario that if ABC had not purchased the $55 call option, the new price of oil of $100 would have made their whole project unprofitable. In scenarios 1 and 2, the call option was not needed in the end, but it only added a small $2 cost, meaning the project was still profitable. In scenario 3 though, the call option was crucial to keeping the project profitable. In comparison to not buying the call option, it saved them $43 per barrel of oil!

So the option only added a small cost in all 3 scenarios, but saved the project from catastrophe in scenario 3. This property of having a fixed cost, but having the potential to pay off big, is what makes the buying of options so attractive in certain circumstances.

This lecture has covered one hypothetical example where a call option would be useful, and we will cover many more examples, including live trades, throughout the rest of the course. In the next lecture though, we will study how to calculate the profit or loss of a call option.