Options - Buying Calls and Puts
Call and put options are examples of stock derivatives - their value is derived from the value of the underlying stock. For example, a call option goes up in price when the price of the underlying stock rises. And you don't have to own the stock to profit from the price rise of the stock.
A put option goes up in price when the price of the underlying stock goes down. As with a call option, you don't have to own the stock. But if you do, the put acts as a hedge - as the stock price goes down, the value of the put goes up so you are hedged against the downside.
You make money on options if your bet on the direction of price movement of the underlying stock is correct. If not, you'll probably loose most or all the money you paid for the option. Options are very sensitive to changes in the price of the underlying stocks. Like gambling you can make or lose money very quickly.
Because option prices change quite rapidly, owning them requires that you spend a significant amount of time monitoring price changes in the stock and the option. And if you're wrong about the price movement, be prepared to lose all or a significant portion of the money you paid for the options.
Buying a Call
A call is a contract that gives the owner the right, but not the obligation, to buy 100 shares of a stock at a fixed price, called the strike price, on or before the options expiration date. For example, assume you buy a June $120 call option (the option expires on the third Friday of June). The strike price is $120. If the stock price reaches $120, the value of the contract increases $100 for each $1 increase of the stock. So if the price of the stock moves from $120 to $135, the value of the option increases by $1,500.
If the price of the stock goes above the strike price and you want to buy the 100 shares, you can exercise the option and buy the 100 shares for $120 per share no matter the current value of the stock.
If the value of the stock goes down, the price of the option goes down, and you could hold it or sell it at a loss.
You may sell the option for a profit or loss anytime before the contract expires.
The price that you pay for a call option depends on many factors two
of which include: the duration of the contract (the longer the duration,
the more you pay) and how far the current price of the stock is from the
strike price of the contract.
What the call buyer may do. . . . .
- Sell option at a profit if the stock price rises. Take profit.
- Sell option at a loss if the stock price does not rise. Lose part of purchase price.
- Let option expire and take loss if the stock price does not rise. Lose all of purchase price.
- Exercise call option if the stock price rises above the strike price. Buy 100 shares at strike price, which is less than market price (buy stock for less than it's worth). Own 100 shares of stock.
Buying a Put
If you own a stock, you may buy a put as a form of insurance. If the stock falls in price, the put rises in price and helps offset the paper decline in the underlying stock. If you don't own the stock but think it will go down in price, you buy the put to profit from the decline in price of the stock. If the stock price declines, the value of the put rises and you would sell the put for a profit. If the stock increases in price you may sell the put for a loss.
A put option is a contract that gives you the right, but not the obligation, to sell a stock at a preset price. For example, if you buy a put with a strike price of $50, you could sell 100 shares of the stock to the put seller when the stock price fell below $50. So if the stock fell to $30, you could sell it for $50 and the seller is obligated to buy the stock at $50 even though the current price is $30 - not a good deal for the put seller.
The price that you pay for a put option depends the duration of the contract (the longer the duration, the more you pay) and how far the current price of the stock is from the strike price of the contract.
Put buying is different from selling short. With a put option your only liability is the price you paid for the put. With a short sale, you have an unlimited downside liability if the stock goes up. Also, the proceeds from selling short are in a margin account so you have to pay interest and meet margin requirements. Buying puts is a more conservative way of betting on a stock declining in price.
What the put buyer may do. . . . .
- Sell option at a profit if the stock price declines. Take profit.
- Sell option at a loss if the stock price does not decline. Lose part of purchase price.
- Let option expire and take loss if the stock price does not decline. Lose all of purchase price.
- Exercise option if the stock price declines. Sell 100 shares at strike price, which is more than market price (sell stock for more than it's worth). Put buyer must own 100 shares to sell. Can already own them or buy them at market price, which is less than strike price. Collect proceeds from stock sale.