Buying Tin Call Options to Profit from a Rise in Tin Prices

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Hedging Against Rising Tin Prices using Tin Futures

Businesses that need to buy significant quantities of tin can hedge against rising tin price by taking up a position in the tin futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of tin that they will require sometime in the future.

To implement the long hedge, enough tin futures are to be purchased to cover the quantity of tin required by the business operator.

Tin Futures Long Hedge Example

A tin can manufacturer will need to procure 500 tonnes of tin in 3 months’ time. The prevailing spot price for tin is USD 11,550/ton while the price of tin futures for delivery in 3 months’ time is USD 12,000/ton. To hedge against a rise in tin price, the tin can manufacturer decided to lock in a future purchase price of USD 12,000/ton by taking a long position in an appropriate number of LME Tin futures contracts. With each LME Tin futures contract covering 5 tonnes of tin, the tin can manufacturer will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the tin can manufacturer will be able to purchase the 500 tonnes of tin at USD 12,000/ton for a total amount of USD 6,000,000. Let’s see how this is achieved by looking at scenarios in which the price of tin makes a significant move either upwards or downwards by delivery date.

Scenario #1: Tin Spot Price Rose by 10% to USD 12,705/ton on Delivery Date

With the increase in tin price to USD 12,705/ton, the tin can manufacturer will now have to pay USD 6,352,500 for the 500 tonnes of tin. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 12,705/ton. As the long futures position was entered at a lower price of USD 12,000/ton, it will have gained USD 12,705 – USD 12,000 = USD 705.00 per tonne. With 100 contracts covering a total of 500 tonnes of tin, the total gain from the long futures position is USD 352,500.

In the end, the higher purchase price is offset by the gain in the tin futures market, resulting in a net payment amount of USD 6,352,500 – USD 352,500 = USD 6,000,000. This amount is equivalent to the amount payable when buying the 500 tonnes of tin at USD 12,000/ton.

Scenario #2: Tin Spot Price Fell by 10% to USD 10,395/ton on Delivery Date

With the spot price having fallen to USD 10,395/ton, the tin can manufacturer will only need to pay USD 5,197,500 for the tin. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the tin futures price will have converged with the tin spot price and will be equal to USD 10,395/ton. As the long futures position was entered at USD 12,000/ton, it will have lost USD 12,000 – USD 10,395 = USD 1,605 per tonne. With 100 contracts covering a total of 500 tonnes, the total loss from the long futures position is USD 802,500

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the tin futures market and the net amount payable will be USD 5,197,500 + USD 802,500 = USD 6,000,000. Once again, this amount is equivalent to buying 500 tonnes of tin at USD 12,000/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the tin buyer would have been better off without the hedge if the price of the commodity fell.

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An alternative way of hedging against rising tin prices while still be able to benefit from a fall in tin price is to buy tin call options.

Learn More About Tin Futures & Options Trading

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Buying a Call Option

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Traders buy a call option in the commodities or futures markets if they expect the underlying futures price to move higher.

Buying a call option entitles the buyer of the option the right to purchase the underlying futures contract at the strike price any time before the contract expires. This rarely happens, and there is not much benefit to doing this, so don’t get caught up in the formal definition of buying a call option.

Most traders buy call options because they believe a commodity market is going to move higher and they want to profit from that move. You can also exit the option before it expires—during market hours, of course.

All options have a limited life. They are defined by a specific expiration date by the futures exchange where it trades. You can visit each futures exchange’s website for specific expiration dates of each commodities market.

Finding the Proper Call Options to Buy

You must first decide on your objectives and then find the best option to buy. Things to consider when buying call options include:

  • Duration of time you plan on being in the trade
  • The amount you can allocate to buying a call option
  • The length of a move you expect from the market

Most commodities and futures have a wide range of options in different expiration months and different strike prices that allow you to pick an option that meets your objectives.

Duration of Time You Plan on Being in the Call Option Trade

This will help you determine how much time you need for a call option. If you are expecting a commodity to complete its move higher within two weeks, you will want to buy a commodity with at least two weeks of time remaining on it. Typically, you don’t want to buy an option with six to nine months remaining if you only plan on being in the trade for a couple of weeks, since the options will be more expensive and you will lose some leverage.

One thing to be aware of is that the time premium of options decays more rapidly in the last 30 days.   Therefore, you could be correct in your assumptions about a trade, but the option loses too much time value and you end up with a loss. We suggest that you always buy an option with 30 more days than you expect to be in the trade.

Amount You Can Allocate to Buying a Call Option

Depending on your account size and risk tolerances, some options may be too expensive for you to buy, or they might not be the right options altogether. In the money call, options will be more expensive than out of the money options. Also, the more time remaining on the call options there is, the more they will cost.

Unlike futures contracts, there is a margin when you buy most options. You have to pay the whole option premium up front. Therefore, options in volatile markets like crude oil can cost several thousand dollars. That may not be suitable for all options traders, and you don’t want to make the mistake of buying deep out of the money options just because they are in your price range. Most deep out of the money options will expire worthlessly, and they are considered long shots.

Length of a Move You Expect From the Market

To maximize your leverage and control your risk, you should have an idea of what type of move you expect from the commodity or futures market. The more conservative approach is usually to buy in the money options.

A more aggressive approach is to buy multiple contracts of out of the money options. Your returns will increase with multiple contracts of out-of-the-money options if the market makes a large move higher. It is also riskier as you have a greater chance of losing the entire option premium if the market doesn’t move.

Call Options vs. a Futures Contract

Your losses on buying a call option are limited to the premium you paid for the option plus commissions and any fees. With a futures contract, you have virtually unlimited loss potential.

Call options also do not move as quickly as futures contracts unless they are deep in the money. This allows a commodity trader to ride out many of the ups and downs in the markets that might force a trader to close a futures contract in order to limit risk.

One of the major drawbacks to buying options is the fact that options lose time value every day. Options are a wasting asset. You not only have to be correct regarding the direction of the market but also on the timing of the move.

Break Even Point on Buying Call Options

Strike Price + Option Premium Paid

This formula is used at option expiration considering there is no time value left on the call options. You can obviously sell the options anytime before expiration and there will be time premium remaining unless the options are deep in the money or far out of the money. 

A Stop-Loss Instrument

A call option can also serve as a limited-risk stop-loss instrument for a short position. In volatile markets, it is advisable for traders and investors to use stops against risk positions. A stop is a function of risk-reward, and as the most successful market participants know, you should never risk more than you are looking to make on any investment.

The problem with stops is that sometimes the market can trade to a level that triggers a stop and then reverse. For those with short positions, a long call option serves as stop-loss protection, but it can give you more time than a stop that closes the position when it trades to the risk level. That is because if the option has time left if the market becomes volatile, the call option serves two purposes.

  1. First, the call option will act as price insurance, protecting the short position from additional losses above the strike price.
  2. Second, and perhaps more importantly, the call option allows the opportunity to stay short even if the price moves above the insured level or the strike price.

Markets often rise only to turn around and fall dramatically after the price triggers stop orders. As long as the option still has time until expiration, the call option will keep a market participant in a short position and allow them to survive a volatile period that eventually returns to a downtrend. A short position together with a long call is essentially the same as a long put position, which has limited risk.

Call options are instruments that can be employed to position directly in a market to bet that the price will appreciate or to protect an existing short position from an adverse price move.

Call Option

What is a Call Option?

A call option, commonly referred to as a “call,” is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock Stock What is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms “stock”, “shares”, and “equity” are used interchangeably. or other financial instrument Financial Assets Financial assets refer to assets that arise from contractual agreements on future cash flows or from owning equity instruments of another entity. A key difference between financial assets and PP&E assets – which typically include land, buildings, and machinery – is the existence of a counterparty. at a specific price – the strike price of the option – within a specified time frame. The seller of the option is obligated to sell the security to the buyer if the latter decides to exercise their option to make a purchase. The buyer of the option can exercise the option at any time prior to a specified expiration date. The expiration date may be three months, six months, or even one year in the future. The seller receives the purchase price for the option, which is based on how close the option strike price is to the price of the underlying security at the time the option is purchased and on how long a period of time remains till the option’s expiration date. In other words, the price of the option is based on how likely, or unlikely, it is that the option buyer will have a chance to profitably exercise the option prior to expiration. Usually, options are sold in lots of 100 shares.

The buyer of a call option seeks to make a profit if and when the price of the underlying asset increases to a price higher than the option strike price. On the other hand, the seller of the call option hopes that the price of the asset will decline, or at least never rise as high as the option strike/exercise price before it expires, in which case the money received for selling the option will be pure profit. If the price of the underlying security does not increase beyond the strike price prior to expiration, then it will not be profitable for the option buyer to exercise the option, and the option will expire worthless, “out of the money”. The buyer will suffer a loss equal to the price paid for the call option. Alternatively, if the price of the underlying security rises above the option strike price, the buyer can profitably exercise the option.

For example, assume you bought an option on 100 shares of a stock, with an option strike price of $30. Before your option expires, the price of the stock rises from $28 to $40. Then you could exercise your right to buy 100 shares of the stock at $30, immediately giving you a $10 per share profit. Your net profit would be 100 shares, times $10 a share, minus whatever purchase price you paid for the option. In this example, if you had paid $200 for the call option, then your net profit would be $800 (100 shares x $10 per share – $200 = $800).

Buying call options enables investors to invest a small amount of capital to potentially profit from a price rise in the underlying security, or to hedge away from positional risks Risk and Return In investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk. . Small investors use options to try to turn small amounts of money into big profits, while corporate and institutional investors use options to increase their marginal revenues Marginal Revenue Marginal Revenue is the revenue that is gained from the sale of an additional unit. It is the revenue that a company can generate for each additional unit sold; there is a marginal cost attached to it, which has to be accounted for. and hedge their stock portfolios.

How Do Call Options Work?

Since call options are derivative instruments, their prices are derived from the price of an underlying security, such as a stock. For example, if a buyer purchases the call option of ABC at a strike price of $100 and with an expiration date of December 31, they will have the right to buy 100 shares of the company any time before or on December 31. The buyer can also sell the options contract to another option buyer at any time before the expiration date, at the prevailing market price of the contract. If the price of the underlying security remains relatively unchanged or declines, then the value of the option will decline as it nears its expiration date.

Investors use call options for the following purposes:

1. Speculation

Call options allow their holders to potentially gain profits from a price rise in an underlying stock while paying only a fraction of the cost of buying actual stock shares. They are a leveraged investment that offers potentially unlimited profits and limited losses (the price paid for the option). Due to the high degree of leverage, call options are considered high-risk investments.

2. Hedging

Investment banks and other institutions use call options as hedging instruments. Just like insurance, hedging with an option opposite your position helps to limit the amount of losses on the underlying instrument should an unforeseen event occur. Call options can be bought and used to hedge short stock portfolios, or sold to hedge against a pullback in long stock portfolios.

Buying a Call Option

The buyer of a call option is referred to as a holder. The holder purchases a call option with the hope that the price will rise beyond the strike price and before the expiration date. The profit earned equals the sale proceeds, minus strike price, premium and any transactional fees associated with the sale. If the price does not increase beyond the strike price, the buyer will not exercise the option. The buyer will suffer a loss equal to the premium of the call option. For example, suppose ABC Company’s stock is selling at $40 and a call option contract with a strike price of $40 and an expiry of one month is priced at $2. The buyer is optimistic that the stock price will rise and pays $200 for one ABC call option with a strike price of $40. If the stock of ABC increases from $40 to $50, the buyer will receive a gross profit of $1000 and a net profit of $800.

Selling a Call Option

Call option sellers, also known as writers, sell call options with the hope that they become worthless at the expiry date. They make money by pocketing the premiums (price) paid to them. Their profit will be reduced, or may even result in a net loss, if the option buyer exercises their option profitably when the underlying security price rises above the option strike price. Call options are sold in the following two ways:

1. Covered Call Option

A call option is covered if the seller of the call option actually owns the underlying stock. Selling the call options on these underlying stocks results in additional income, and will offset any expected declines in the stock price. The option seller is “covered” against a loss since in the event that the option buyer exercises their option, the seller can provide the buyer with shares of the stock that he has already purchased at a price below the strike price of the option. The seller’s profit in owning the underlying stock will be limited to the stock’s rise to the option strike price but he will be protected against any actual loss.

2. Naked Call Option

A naked call option is when an option seller sells a call option without owning the underlying stock. Naked short selling of options is considered very risky since there is no limit to how high a stock’s price can go and the option seller is not “covered” against potential losses by owning the underlying stock. When a call option buyer exercises his right, the naked option seller is obligated to buy the stock at the current market price to provide the shares to the option holder. If the stock price exceeds the call option’s strike price, then the difference between the current market price and the strike price represents the loss to the seller. Most option sellers charge a high fee to compensate for any losses that may occur.

Call vs. Put Option

A call and put option are the opposite of each other. A call option is the right to buy an underlying stock at a predetermined price up until a specified expiration date. On the contrary, a put option is the right to sell the underlying stock at a predetermined price until a fixed expiry date. While a call option buyer has the right (but not obligation) to buy shares at the strike price before or on the expiry date, a put option buyer has the right to sell shares at the strike price.

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