What is a call option?
Let’s say that gas is around $3.75 per gallon. Do you think it’s going higher? No, I mean really. Do you really think it’s going higher in, say, the next three months?
If you do, then you could go on down to your local gas station, meet with the owners and make a proposition. You could tell them this:
“I’d like to enter a contract with you. I want to be able to buy 100 gallons of gas at the current price of $3.75 per gallon at any time between now and the end of August 2008. Can we make a deal?”
Naturally, the gas station owner is going to put a price tag on this deal. After all, why would he lock in this price for you when gas could go higher? On the other hand, for the right price, he might be willing to make this deal. Why? Because it’s also possible that gas doesn’t go higher and selling this contract could bring in some extra cash for him. Let’s say he agrees to sell you this contract for thirty cents per gallon, or $30. You accept and the deal is done.
This contract you have created is a call option on gasoline. It is just like the call options you can easily buy and sell on many stocks, indexes, futures and other products. It has a strike price ($3.75/gallon), an expiration date (August 31, 2008) and a price ($0.30/gallon). It also contains 100 gallons per contract, just as equity / index options usually trade at 100 shares / contract.