This article explains put options and call options futures trading, how said options are priced, and provides a brief comparison to short selling.
Most investors saving for retirement are familiar with investment vehicles such as savings bonds, stocks and mutual funds.
There are some additional investments available with the possibility of far higher returns which can be made within days or even hours of purchase. These investments are often not for the faint of heart or investors without much discretionary income or funds available, but may be appropriate for some individuals. In any event, the knowledge of how those investments work may be beneficial to all. These riskier investments include put options and call options on specific stocks. This is a type of futures trading which is similar to commodities trading, however the ‘future’ price being selected by the trader is that of a stock and not of a commodity.
When investors buy or sell put and call stock options, they are not buying or selling actual shares or mutual funds. They are buying the right to buy or sell a security at a certain price on a certain date. The stock option that allows the investor to purchase the security at a stated price on a certain date is called a ‘call option’, and the option that allows the investor to sell the security at said price on said date is called a ‘put option.’
Factors Which May Determine Price of Options
The price at which the option is set is influenced by various factors. Options with an date on which they can be exercised farther in the future may be more expensive than those with a closer date (though in some circumstances such as where a put option can be exercised at a profit almost immediately at a price unlikely to be retained the inverse would of course be true).
Similarly an option that allows one to sell a security at a higher price or buy a security at a lower price is generally going to be more expensive than the alternative. This could again change if there is anticipated movement one way or the other in the value of the underlying security prior to the date for exercising the option.
Volatility of Options
As anyone who has tracked the price of put and call options knows, the price of the options is very volatile – generally much more volatile than the price of the underlying security. If the underlying security appears to be heading upwards in value, the price of the call options trading on the security may move upwards very quickly, while the put options previously written may become of almost no value (or in fact of no value).
Comparison to Short Selling
An investor is able to make considerable income in a falling market by purchasing, and then selling at a profit, put options. Similarly, large sums of money can also be made selling stocks short – that is selling shares not currently owned with the intention of purchasing them at a lower price and covering the short sale in the near future.
Depending on the value of the put options, there may be advantages in trading in said options rather than selling short. Comparable profits may be available in either trading scheme. If the market makes an unexpected jump upwards however, traders who have sold security short must cover the short sale at the current (much higher) trading prices of the security. Traders who have invested in the put options will likely lose the whole amount of their investment in them, but will not be obligated to purchase any shares at a price which may be devastating.