What Investors Need to Know to Play the Options Game
Stock options involve the right or obligation to buy or sell a stock at a fixed price within a fixed period of time. There are two main types: call options and put options.
Call Options
The buyer of a call option has the right, or option, of buying a particular stock at the fixed price (called the strike price), within a given time frame. The buyer pays a small amount for each option contract, called the premium. Each option contract consists of 100 shares. The buyer is speculating the underlying stock will be bullish.
The seller (also called “the writer”) has the obligation to sell the stock at that fixed price, within the given time frame. The seller is betting that the underlying stock will be bearish.
Call Option Example
Company AAA’s stock is currently selling for $30. Assume a call option contract allows the buyer the right to buy the stock at the strike price of $35 within 3 months from now. Assume the buyer pays a premium of $1. Say the stock jumps to $40. The buyer exercises the call, and make a profit of $4 per contract ($5 minus the premium paid).
The seller has to provide the stock. If the seller owns the stock already, the seller is called a covered seller. Most likely it was bought at less than $35. If the seller has to go out on the secondary market and buy it, the seller is called an uncovered seller.
The break-even point for the buyer is the strike price plus the premium (36). If the stock doesn’t go above 36, the buyer will not exercise the call and the loss is limited to the premium paid. Theoretically, the buyer’s potential gain is unlimited, since there is no limit on how much the stock may rise.
The seller will make money, consisting of the premium, if the stock stays at 30, dips below 30, or does not exceed the buyer’s break-even point.
Put Options
The buyer has the right to sell the stock at the strike price, within the specified time period. A premium, again, is paid for this right. The buyer is speculating that the underlying stock will be bearish. The seller has the obligation to buy the stock at the strike price, within the fixed time period. The seller is betting the stock will be bullish.
Put Option Example
Company AAA’s stock is currently selling for $30. Assume a put option contract allows the buyer the right to sell the stock at the strike price of $25 within 3 months from now. Assume the buyer pays a premium of $1. Say the stock drops to $20. The buyer exercises the put, and makes a profit of $4 per contract ($5 minus the premium paid).
The seller is contractually bound to purchase the stock at the strike price.
The break-even point for the buyer is the strike price minus the premium (24). If the stock doesn’t go below the break-even point, the buyer will not exercise the put, and the loss is the premium paid.
The seller will make money, consisting of the premium, if the stock price doesn’t move, or goes up, or doesn’t go below the buyer’s break-even point.
Option Terminalogy
Call option In-the-money: Strike price less than underlying stock price
Put option In-the-money: Strike price more than stock price
Call and Put option At-the-money: Strike price equals the stock price
Call option Out-of -the-money: Strike price more than stock price
Put option Out-of-the-money: strike price less than stock price
Most investors don’t just trade options, but use it as part of their portfolio plan, inasmuch as stocks represent ownership in a company, while an option is simply a contract between a buyer and a seller.
