Stock Options For Dummies
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The two most common types of traded options are calls and puts. A call option, lets you speculate on prices of the underlying asset rising. A put option, lets you bet on their fall.

What's a call option all about?

Call options give you the right to buy a defined amount of the underlying asset at a certain price before a certain amount of time expires. (Think of it as a bet that the underlying asset is going to rise in value.) If you don’t buy the asset by the time the option expires, you lose only the money that you spent on the call option.

When you buy a call option, you put up the option premium for the right to exercise an option to buy the underlying asset before the call option expires. When you exercise a call, you’re buying the underlying stock or asset at the strike price, the predetermined price at which an option will be delivered when it is exercised.

The attractiveness of buying call options is that the upside potential is huge, and the downside risk is limited to the original premium — the price you pay for the option.

You can always sell your option prior to expiration to avoid exercising it, to avoid further loss, or to profit if it has risen in value. Call options usually rise in price when the underlying asset rises in price.

Buying call options example

Assume that you think XYZ stock in the above figure is going to trade above $30 per share by the expiration date, the third Friday of the month. So you buy a $30 call option for $2, with a value of $200, plus commission, plus any other required fees.

If you’re right, and XYZ is up to $35 per share by the expiration date, you can exercise your option, buy 100 shares of XYZ at $30, which costs you $3,000 and then sell it on the open market at $35, realizing a gain of $500 minus your initial $200 premium, commissions, and other fees. In this case, your option is in the money, because the strike price is less than the market price of the underlying asset.

When you, the option holder, put in your order, the dealer searches for someone on the other side of the trade, in other words, the option writer, with the same class and strike price of the option. The writer is then assigned the trade and must sell his shares to you if you exercise the option. So, a call assignment requires the writer, the trader who sold the call option to you, to sell his stock to you. A put assignment, on the other hand, requires the person who sold you the put on the other side of the trade (again, the put writer) to buy the stock from you, the put holder.

You have two other possibilities: You can hold the stock, knowing that you have a $5 cushion because you bought it at a discount, or you can sell the option back to the market, hopefully at a profit. According to the CBOE, most options are never exercised. Instead, most traders sell the option back to the market.

Following up after buying a call option

If you haven’t dealt with call options before, you need to be aware of a few ground rules. Here’s what you should do after you buy a call option:
  • If the underlying stock tanks, the best course is to sell the call option and cut your losses.

  • If the option rises in price, especially if it doubles in a short period of time, take some profits.

  • It’s better to sell a call than to exercise it because the commission costs to buy the stock when you exercise the call are usually more than what it costs to sell the option. If you then turn around and sell the stock, you’ll pay more of a commission at that time as well.

  • If you buy several options and the stock rises significantly, you can take partial profits by selling a portion of your overall position. For example, if you bought five calls and the position is profitable, you can sell three calls and ride the profit train with the remaining ones.

  • If you decide to do nothing, you can lose everything at expiration. But if you sell your profitable initial position and stay out of the options in that particular stock, you can keep your profit. (You may find that a good profit in your pocket is better than a great one that may never come.)

At the beginning of an options trading strategy, keeping it simple is the best way to go. As you become more experienced, you can start making more sophisticated bets.

What's a put option?

Put options are bets that the price of the underlying asset is going to fall. Puts are excellent trading instruments when you’re trying to guard against losses in stocks, futures contracts, or commodities that you already own. Buying a put option gives you the right to sell a specific quantity of the underlying asset at a predetermined price (the strike price) during a certain amount of time. Like calls, if you don’t exercise a put option, your risk is limited to the option premium or the price you paid for it.

When you exercise a put option, you’re exercising your right to sell the underlying asset at the strike price. Puts are sometimes thought of as portfolio insurance because they give you the option of selling a falling stock at a predetermined strike price. You can also sell puts.

Buying a put option example

Here is a typical situation where buying a put option can be beneficial: Say, for example, that you bought XYZ at $31, but you start getting concerned because the stock price is starting to drift down because the market is weakening.

A good way to protect yourself when you’re in this situation is to buy a put option. So you decide to buy an August 30 put for a $1 premium, which costs you $100. By buying the put, you’re locking in the value of your stock at $30 per share until the expiration date on the third Friday in August. If the stock price falls to $20 per share, you still can sell it to someone at $30 per share, as long as the option has not expired. Indeed, the put option gives you the right to sell the stock at $30 no matter how low the price falls.

Using the put option as portfolio insurance fixes your worst risk at $200, which includes the $100 premium you paid for the put option and the $1 per share you can lose after originally paying $31 per share for the stock if you exercise the put. Your other alternative when the stock falls below $30 is to sell the put to the market and profit from the appreciation of the option while holding onto the stock.

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