Puts and Calls are essentially the main two components of options trading. They are the only two types of stock options. Everything else is just a variation or combination of Puts and Calls.
** For the sake of simplicity, I'm only going to refer to stock options, even though options can be traded on stocks, exchange-traded funds, indices, commodities, etc.**
Last week we discussed options trading and briefly explained the concept of trading these contracts (Puts and Calls). Let's do a quick recap:
Stock Options are contracts; they don't represent ownership in anything. They are merely contracts that grant you certain rights. In the case of a stock it gives you the "right", but not the obligation, to buy (Calls) or sell (Puts) shares of a stock at a set price on or before a given date.
An options trader is in the business of buying and selling contracts.
A stock option is often referred to as a derivative and its value is dependent on the price of the stock it was created for. The contracts go up or down in value as the underlying asset (stock) goes up and down in value.
2 Types of Stock Options: Puts and Calls
The "Put" option gives its buyer the right, but not the obligation, to sell shares of a stock at a specified price on or before a given date. After this date, your contract expires and your option ceases to exist.
The "Call" option gives its buyer the right, but not the obligation, to buy shares of a stock at a specified price on or before a given date. After this date, your contract expires and your option ceases to exist.
Stock option contracts grant you the rights listed above, but you don't have to buy or sell the stock if you don't want to. If you don't exercise the rights of your contract then you simply lose the money paid for the contracts.
This is why Puts and Calls are called wasting assets. They have expiration dates. A stock option is nothing but a contract, and like most contracts they are only valid for a set period of time.
For example, I have a one year contract with a local gym here. It gives me the right, but not the obligation, to go to the gym whenever I want for a year. They don't make me go, but if I don't exercise my right to go then I lose the money I paid for this right. After a year my contract ends and I no longer have the right to workout at that particular gym.
Puts and Calls in Action
1 stock option contract = 100 shares of a company's stock. So when you buy 1 contract you are buying the right to buy or sell 100 shares of that stock.
Puts and Calls allow you to make money whether the stock market is going up, down, or sideways. This will only make sense if you understand how these two contracts work so let's dig deeper.
"Put options" increase in value when the underlying stock it's attached to declines in price, and decrease in value when the stock goes up in price. Remember Put options give you the right to sell a stock at a specified price.
For instance if you bought an IBM December 130 "Put option", the option (contract) gives you the right to "sell" IBM stock for a price of $130 on or before the third Friday of December.
If IBM falls below $130 before the 3rd Friday in December you have the right to sell the stock for more than its market value. So let's say that IBM falls in price to $76. Everyone else who owns the stock has to sell it for $76, but you own a contract that says you can sell it for $130!
Now can you see why Put option contracts go up in value as the underlying stock goes down in price? The further the stock falls in price below your exercise price ($130) the more valuable the option becomes.
"Call options" increase in value when the underlying stock it's attached to goes up in price, and decrease in value when the stock goes down in price. Remember Call options give you the right to buy a stock at a specified price.
Let's say you bought an IBM December 95 "Call option" instead. This option gives you the right to "buy" IBM stock for $95 on or before the 3rd Friday of December.
Now imagine that IBM comes out with a new product and the stock shoots up in price to $127. You own a contract (Call option) that says you can purchase it for $95 a share. Think shopping, you get to buy it at a ($32) discount or sales price when everyone else has to pay the full retail price.
So as the stock goes up in price, the 95 Call option goes up in value. A $140 stock price means you get a $45 discount in price etc. etc. And vice versa, if the stock falls in price to $50 a share who wants to purchase a contract that gives them the right to purchase it at $95, when it's selling cheaper on the open market.
If you exercised the right and bought the stock at $95 you'd immediately be at a loss of $45 since the stock is trading for $50 on the open market. That's the equivalent of someone trying to sell you a car for $2000 when the blue book value of it is $1500.
**Tip** The easiest way to understand the difference between Puts and Calls is to realize that they function opposite of each other.
Most Puts and Calls are never exercised (the stock is never bought or sold). Option traders buy and resell stock options before their expiration date. This is primarily because minor fluctuations in the price of the stock can have a major impact on the price of an option. So if the value of an option increases sufficiently, it often makes sense to sell it for a quick profit.
Now of course this is only one reason why someone would trade options. There are numerous reasons why people trade options and just as many strategies to go along with those reasons.
If you're interested in learning how to trade stock options just take your time and make sure you fully understand the concepts before you engage in any real money trading. Confusion on top of confusion just equals more confusion. Take the time to learn it right the first time; it will be well worth your time.
For more information on puts and calls and to learn how to trade stock options go to http://www.learn-stock-options-trading.com/.
Question, comments, or feedback on these two post? Leave your response below, and I'll try to follow up on future option post.
Trade With Prudence,
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