When the topic of options trading arises among most people, the topic discussed regards buying options in anticipation of a stock price moving in a predicted direction. If an options trader thinks the price of a stock will rise, s/he might purchase a ” call option “. A call option gives its owner the right ( but not the obligation ) to purchase 100 shares of stock when they rise above a ” strike price “. For example, if a stock is currently trading at $50.00/share, and an investor thinks the stock price will rise to $60.00/share ( or more ) in some defined time frame, s/he may purchase a call option with a strike price of $55.00. Owning 100 shares of stock worth $55.00 outright would cost $5,500.00; however, the right to do so ( given by purchase of a call option contract ) is much less expensive, but there is a caveat: OPTIONS CONTRACTS HAVE EXPIRATION DATES.
If the underlying stock price does not rise above the strike price before the expiration date, the contract will expire worthless. In this hypothetical example, if the call option rises to $60.00 before the expiration date, the contract holder has the right to either ( 1 ) purchase 100 shares of stock valued at $6,000.00 for $5,500.00, or ( 2 ) sell the contract on the open market before the expiration date. The sale of the contract will net the same profit that buying and immediately selling the stock would garner ( minus transaction fees ). For these reasons, options traders make substantially great profits by investing in contracts that are cheaper than buying 100 shares of stock outright.
To the contrary, if an investor believes that a stock’s price will fall in value, s/he may purchase a ” put option “. A put option gives an investor the right ( but not the obligation ) to SELL 100 shares of a stock at a given strike price. If a stock is currently trading at $50.00/share, and an investor believes the shares may fall, s/he would purchase a put option with a strike price somewhere below $50.00/share.
NOTE: The topic of selling ” naked ” options was intentionally omitted.
For a novice, selling put options is a bit risky ( to say the least ), so the discussion of selling options contracts will be limited to selling covered call options. Let’s say an investor owns 100 shares of a stock valued at $50.00/share. S/he wants to earn some money by selling the right for someone ( or entity ) to purchase the shares if they rise above $55.00/share. The contract sold has an expiration date, and the seller is paid a modest premium upon selling the covered call options contract.
If the underlying stock price does not rise above $55.00/share before the contract’s expiration date, the seller keeps the premium s/he earned, and they keep the 100 shares of stock in their possession. If, however, the underlying stock price rises above $55.00/share, the contract seller would be obligated to sell 100 shares of stock for $55.00. The seller would still keep the premium they earned when the sale was made, and since they’re selling 100 shares for a profit of $5.00/share, they would net an extra $500.00.
What is the downside of selling covered call options? Limited upside potential. The person who sold the covered call contract in the above scenario would net $500.00, but if the stock rises above the strike price, they’re making less money than they would have made if they’d held the shares. Additionally, let’s say that the underlying share price fell to $45.00 and stayed there until the expiration date. The contract seller would keep the premium s/he earned, but they’d now own shares of stock that decreased by $5.00/share. Let’s assume that the premium earned was $100.00. Split into 100 different parts, this would average out to be a profit of $1.00/share on 100 shares of stock that originally cost $50.00. If another covered call option were sold ( current stock price at $45.00/share ), the contract seller would not want to sell a contract with a strike price less than $49.00, because selling the 100 shares for $49.00/share would cause them to ” break even “, and they’d be back to square one in terms of earnings.
This is by no means an all-intensive discussion about options contracts. Even the savviest of investors assume major risks when trading options, so the utmost of care must be taken when buying or selling them.
RENAISSANCE PHYSICS 