Exercise the call option when spot price is less than strike price.

The owner of a call option on oil futures with a striker price of $50

: would never exercise the option when the spot price of oil is les than the striker price.

Why is the above a wrong answer?

An option is in the money when S>X, or market price of underlying stock is more than the strike price. In this case, market price is the spot price.

It’s because you have to account for the cost of the option as well. For instance the call option premium is $3, the strike is 50. The underlying goes to 45. Of course you would not exercise it, the option expires worthless , and you lose the $3 option premium, leaving you with a net loss of $3 (or -$3 , however you want to look at it).

Now say the underlying stops at $49 on option expiration date. You exercise your call because the option premium is $3 and you can choose to lose either $1 by exercising your call or $3 by letting your option expire worthless and lose the $3 premium that you paid for the option. Therefore any investor would take the $1 hit over the $3 hit and exercise their call.

Another way to look at it, is the break even price of a call option is $53, that is if the underlying is $53, if the strike is 50 and the premium is $3. If the stock goes to $52, the option is technically in-the-money, and you exercise it, gaining $2 in the process. However, the premium costed you $3 so you end with a net loss of $1. If the underlying hits $53 and you exercise it, you gain $3 on the option, which cancels out the $3 you paid for the premium, leaving you with a net of $0, thus, breaking even.

Anyways that’s how I figured it , so if any of the more experienced candidates/ charterholders want to chime in please feel free to.

^ I don’t think that’s how it will work. In your scenario, if the stock price is 49, the total loss if he exercises it would be $4 ($3 from the option premium and $1 from the loss on payoff). The $3 option premium has already been paid, so it shouldn’t be considered when deciding whether or not to exercise the option.

What other answer options were you given OP?

The other option is : can exercise the option and take a long position in oil futures

My guess is that because the question deals with futures.

Futures price = spot price + storage costs - convenience yield

So, even if the spot price is below the strike price, the future price may be higher than the strike price(contango, lol, such a brilliant word, so fun to say :smiley: ), so, when the future contract price is higher than the strike price, the option would be exercised.

Therefore, the other option you posted seems to be more appropriate.