Essentially option trading is a bet that you can place on a security/stock if you think the price will go up/down/stay the same for a period of time. If you are right, you can make a great deal of money with comparably little investment. On the other hand, if you are wrong, you will mostly like lose all the investment you put in for the option.
Let’s dig in a little bit further. Generally there are “call option” versus “put option”. To put it simply, buying a call option is betting the stock will go up whereas buying a put option is betting the stock will go down.
First the general lingo:
Buy to Open: When either buying (open) or an either call or put option
Sell to Close: When either selling (close) an either call or put option
In The Money (ITM): ATM + the price of you paid for the option
Buy Call option: Let’s say a stock is selling for $100/share, and the call with an expiration date of two weeks from now is selling at $10/share for at the money of $130 (options usually expires on the Fridays). You buy 1 contract, which controls 100 shares of the stock (there are mini option that control 10 shares, but let’s stick with 100 for now). So you paid $1000 for the one contract, now controls 100 shares of the stock which would cost you $100,000 on fair market price. So now all you have to do is wait to see if the stock will go above $150 in the two weeks. If the company happens to report a very good earning and the price shot up to $180, which mean you are In The Money, then (180-130-10)*100 = $4000, you just quadrupled your investment of $1000! On the other hand however if the stock never go over 140(130+10) is your breakeven point), the value of the option will go down fairly quickly to zero as it gets to expiration. You can sell it before to recover some money, but for a short term option like two weeks and the stock you bought “call option” is falling in price, you most likely will lose most if not all investment. The other outcome is when the price of the stock is at $130, whch mean you are At The Money, then you option will not be worth much if it's near expiration date because you pretty much broken even minus the premium you paid for the option.
Buy Put option: Let’s say a stock is selling for $100, and the call with an expiration date of two weeks from now is selling at $10/share for at the money of $70 (options usually expires on the Fridays). You buy 1 contract, which controls 100 shares of the stock, so you paid $1000 for the one contract, now controls 100 shares of the stock which would cost you $100,000 on fair market price. So now all you have to do is wait to see if the stock will go below 70 in the two weeks. If within those two weeks, it happens to report a much worse than expected income report or God forbids there was some kind of SEC investigation in its accounting reporting, and the price went down to $20, then (70-20-10)*100 = $4000, you just quadrupled your investment of $1000! On the other hand however if the stock never go below $60 ($70-$10 is your breakeven price for the put option) the value of the option will go down fairly quickly to zero as it gets to expiration. Again, you can sell it before to recover some money, but usually not much if it’s a short term option.
You can also write a call or put option. They work essentially the opposite of buying the respective option.
Write(Sell) Call Option: Let’s say you have 10,000 shares of a stock. It’s been sitting there for a long time with little or no dividends. If you think the price of the stock should be stable in the near future or might not go up much, you can make some extra cash by write a call option on those shares. With 10,000 shares, you can write up to 100 contracts since each contract controls 100 shares. So for example if the stock is $20/share, and you write the call option $25 at the money for $1 with one month till expiration, if someone bought those 100 contracts, they have to pay you 100*100*1=10,000. If within the month of time the stock never reached in the money ($25+$1=$26), then you just made $10,000 that month. However if the stock somehow way above $26, let’s say 36 and the option buyer decide to exercise the option, that means you must sell your 10,000 shares at $25, so your loss would be $36*100*100-(25+1)*100*100= $10,000. I count it as a loss since you could’ve made that money yourself by selling the shares at market price.
Write(Sell) Put Option: Essentially it works similar to writing a call option except betting on the price will not go down much/stable. One thing to be noted is that writing a call option expose the writer to much greater financial risk since theoretically the price of a stock can go up forever, then you are talking about astronomical when you have to pony up the shares whereas if you are put writer, the most you can lose is the price to the stock since the stock can't go below $0. Writing a call option is even riskier if you write a naked call (as opposed to covered call) where you don’t own the shares of stock you are writing the call option on, so when the buyer decides to exercise the call option he bought from you, you will have to buy the shares at the risen price, but sell it at the agreed price where the option was written on.
Of course, thanks to financial engineering where dreams are built, there are a whole wide range of positions you can place on the options of a stock such as strangle, iron butterfly, straddle, bull put spread, and bear call spread. They are essentially a mix of buying and selling put and call that could sometimes limit the exposed risks as well as profit. I will try to cover them in future articles.
Words of caution: first, option buy and selling is not the same as investing. It's borderline speculating/betting and thus a high risk investment. Please tread carefully when trading options because you might even lose the your shirt on your back if you risk too much money. The rule of thumb is not to invest(bet) more than 5% of your investment portfolio in option or speculation in general. Also from my personal experiences, it's better to buy long term options opposed to short term such as a month or less. Of course you will probabaly pay more premium for longer term options, but you get more time and better chance of something might happen that will affect the price of the stock and cause the price of the options to swing your way. Remember time is instrinsic to the value of the options, it's one of the main factor that goes in the formula for writing an option, along with the price and violatility of the stock. Good luck trading! If you have specific question, please email firstname.lastname@example.org or comment below.
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