Option trading in the stock market seems simple at first, but there are many different facets and strategies to trading options. Buying calls and puts let you profit quickly if you are correct in the direction a stock or index will move. Options can be traded on almost any stock or index. This will explain the basics of buying calls and puts on stocks and indexes.
How Options Differ from Stocks
When you buy a stock, there is no time limit to owning it. Stocks don’t expire on some date and there is no time limit when you have to get rid of them.
With options, there is a time limit to how long you can own them. At some point in time every option expires and you either just let it expire or you exercise it. Options usually expire on the third Friday of every month though some are different. Make sure you know when your particular option expires.
Terminology
A call option is one that you buy expecting the stock price to increase and a put option is an option you buy if you expect the price of a stock to drop. Underlying stock is the actual stock that a certain option if for. Strike price is the price at which your option is in or out of the money compared to the underlying stock price.
Out-of-the-money means the option has only time value. At-the-money means that the strike price of your option is equal to the underlying stock. An in-the-money option means you are currently making a profit because the underlying stock price is above for call options and below for put options.
Buying Options
You can buy options as opposed to selling (writing) them. When you buy an option that gives you the right but not the obligation to buy or sell the underlying.
Value of Options
There is what is called time value, and that means that the amount of time on any option remaining before the expiration date is valued at some value, the closer the option gets to its expiration date, the less time value there is.
There is also the intrinsic value and that is the value of the option it is in the money. The value of options is also dependant on the VIX, which is the volatility index and current interest rates.
Buying Call Options
When you buy a call you are expecting the underlying stock to increase in price in a given time frame, before the option expires. For example you think that GE is going to increase in price within the next six weeks.
GE is the underlying stock of this example option. Today, March 8, 2009 the price of GE stock is $7.06. You think that GE is going to go to $7.50 or higher by the middle of April, so you could buy an April GE call option.
There are many options in the chain you can buy. For this example you decide to buy a 7.50 April call option. What that means is that you expect GE to go to or above $7.50 before the third Friday in April.
That option will cost you .85 cents per option. Each option is 100 shares of the underlying stock. When you buy one option you are actually buying control of 100 shares. You decide to buy 10 of these call options. That will cost you $850. It is .85 x 100 shares per option x 10 options, which equals $850. You will now control 1,000 shares of GE.
These would be out of the money options since you own the $7.50 options and the stock price is below that $7.50. The 85 cents per option you paid is only for time value. The closer the option gets to its expiration date, the faster the time value will disappear.
If the price of the underlying stock, in this case GE gets above $7.50, the option is then in the money. It will be valued at the time remaining and the intrinsic value it is above the strike price of $7.50. You can sell your options at any time before they expire.
If the price of GE gets at or above the strike price of $7.50, you can sell it at any time for a profit. If the price of GE wasn’t increasing as you expected and it is getting close to expiration, you can sell it before expiration to limit your losses. If you continue to hold the option until expiration and GE never gets to the strike price, it will expire worthless and you would lose the $850.
For example, the price of GE did increase and your options went up to $1.50 per option before expiration. You could sell those options that day for $1,500 for a profit of $650.
Most people trade options strictly for the leveraging that they give them and profit by the expected move and then sell the options for the profit. You have the right to buy the stock of GE as well from the person who sold you the call options.
For example, if GE goes to $8.20 before the expiration date. You can buy those 1000 shares of GE at the price of $7.50 per share. You would need to pay $7,500 for those shares. You would then have been able to lock in your price of GE stock at $7.50 and then purchase it, or you could immediately turn around and sell them at $8.20 per share for $8,200 and profit $700 minus the commission costs.
You might ask why instead of fooling around with options, why not just buy the stock of GE in the first place and not worry about expiring worthless. That is a valid question. It has to do with leverage and percentages.
Buying GE for the $7,500 and selling for $8,200 is a gain of $700, a percentage gain of 9.3%. Using $7,500 of your capital to gain $700 is a gain of 9.3%. But using only $850 of your capital for a $650 gain is a 76% gain.
Buying Put Options
A put option is the same as the above concerning call options, except reversed. You buy a put option when you expect a stock or index to go down. Put options give you the right to sell the underlying stock but not the obligation.
Again most people use stock options for the leverage and usually don’t exercise them for the actual stock. In the case of puts you think GE is going down to $6.50 or lower and you might buy 10 April $6.50 puts for .85 cents.
This would cost you $850. If GE were to go to $6.00 before the expiration date, the option would have time value and intrinsic value and you could sell the options for the profit. Or you would have the right to buy those 1000 shares of GE at the current price of $6.00 and immediately sell them for the optioned price of $6.50.
Options are risky since you not only have to be correct about the direction of the underlying stock or index and you also have to be correct with the time frame as well.
According to the CBOE about 30% of options expire worthless. That doesn’t mean to say that all the others were sold at profits, many are sold to limit the losses they are incurring before expiration. One of the most popular index options that traders' trade is the OEX, which is the S&P 100.
Conclusion
Option trading is a great way to profit quickly if you are correct in the direction of a stock or index, but you can also lose quickly if you are wrong about the timing and or the direction of the price movement. Options can also be used to hedge against loss and risk.
Copyright © 2009 Sam Montana
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