Options 101

Option trading provides many advantages over other investment vehicles.

Option trading is very attractive for both the small and large investor as it provides the opportunity to trade a very large exposure whilst only outlaying a small amount of capital.

Options are a great way to get into the markets at a fraction of the cost, rather than buying the underlying asset outright.

CALL Up: Buyers

A CALL option is a contract that gives the buyer the right to buy shares of stock at a certain price (strike price) on or before a particular day (expiration day).

In other words, suppose a trader is interested in a stock but isn’t sure if they want to buy it today because of the high price of the stock in the open market.

Instead of buying the shares, they buy a CALL option that gives her the right to buy the shares on or before a later day (expiration day), at a specified price (strike price).

This gives the potential to profit (or lose) if the stock makes a move. It gives more time to decide whether or not they want to spend the money on the shares. The cost of the option is the premium.

Now, let’s imagine that there was a huge influx of Kobe beef to the U.S. The high supply of beef caused steak dinner prices to tumble, and the restaurant is now offering the same steak dinner for $20.

Buying a CALL option is kind of like buying a coupon for a dinner at half the price, from one of those group coupon sites.

For example, you pay $25 for a coupon that entitles you to a $50 Kobe beef steak dinner.

However, suppose new trade restrictions and tariffs on Japanese beef have recently caused the regular price of the dinner to rise to $55.

Suddenly, the coupon is worth more than you paid for it because, although you are still entitled to the same steak dinner, its value has risen by five dollars, from $50 to $55.

So now you may have a choice.

Suppose your brother-in-law is interested in using the coupon, and has offered you $30 for your coupon.

CALL Up: Seller

A CALL option is a contract that obligates the seller to sell shares of the stock at a certain price (strike price) on or before a particular day (expiration day).

As a CALL seller, you’re bearish or at least neutral on the underlying stock because you are taking the other side of the bullish CALL buyer.

Depending on the CALL option you sell, you don’t have to be super bearish. In fact, you can be relatively neutral.

Do you remember how we said that options can also depreciate? Well, as a CALL seller, the depreciation works to your benefit.

If you sold a CALL that obligates you to sell shares of the stock at $50, as long as the stock price stays below $50, you likely won’t have to sell your shares.

This agreed-upon price is the strike price—that’s price at which you “struck” a deal.

However there is a chance you could be assigned at any time, even if stock price is below the strike price.

When you sell a CALL option, you receive a credit.

This credit is for you to keep no matter what happens. However, this doesn’t mean you’ll profit no matter what happens. If the stock rallies above the strike price, you are obligated to sell the shares at the lower (strike) price.

If you don’t possess the shares you’ll have to buy them at the higher (current market) price. Theoretically a stock price could climb forever. If you do have the shares in your account then you just missed out any price movement above the strike price.

You do have the ability to buy back the option. So, if the price does start rise, you could close the contract. This may result in a smaller profit than the credit or a loss.

PUT Down

A PUT option is a contract that gives the buyer the right to sell shares of stock at a certain price (strike price) on or before a particular day (expiration day).

Imagine a trader is considering selling a stock or simply thinks a stock’s price is going to fall.

So, he buys a PUT that locks in a sale price. A PUT allows him to sell his stock at a set price, the strike price, so that if the stock price falls, he can exercise the PUT contract.

For investors who do not own stock, a PUT is a bear-market vehicle that allows them to speculate on whether or not a stock will fall.

No matter which strategy you use, the PUT increases in value as the underlying stock price falls.

Remember, as time passes, options depreciate in value.

A PUT option is a contract that obligates the seller to buy shares at a certain price (strike price) on or before a particular day (expiration day).

When you sell a PUT, you are taking the other side of the put buyer’s bearish trade, which makes your side of the trade bullish.

Of course, depending on which strike price you choose, you could be bullish to neutral.

You simply want the stock price to stay above the strike price and the option value to decline under time decay, making your trade profitable.

CALL PUT
LONG
* Buyer of options contract
* Has the right to exercise contract
LONG CALL
* Buying the right to buy the underlying at the strike price
* Bullish
LONG PUT
* Buying the right to sell the underlying at the strike price
* Bearish
SHORT
* Seller of options contract
* Obligated to fulfill contract if exercised
SHORT CALL
* Obligated to sell the underlying at the strike price
* Bearish
SHORT PUT
* Obligated to buy the underlying at the strike price
* Bullish

Conclusion

The basic concepts of options, including definitions for CALLS and PUTS are as contain above.

We have shown some of the benefits and risks to buying options versus selling options within the examples.

We have only scratched the surface of the many option trade opportunities. At Smart Money Option, our traders have over 20 years experience within the industry. We are more than happy to answer any questions you may have.

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