The Millionaire Blog

Many readers wanted me to go through the fundamentals of Options. Here you go :-

Options - Calls and Puts

A ‘call’ confers on the (option) contract holder the right to buy an asset at a stated price on or before a specified expiration date. A right to buy, not an obligation. The call owner always has the option to let his option expire. Remember when you buy a call, you have the right and not an obligation. This is very important; basically you don’t risk anything other than the premium.

Call buyers are betting the underlying asset - the stock, bond, commodity, etc - will increase in price before the expiration date. And, not only rise, but rise enough to make a profit.

How much is enough?

The price must rise enough to cover the difference between the market price and the strike price (the price at which the stock, say, must be bought). And, since the option itself has a cost, the price has to rise enough to cover that additional amount. That cost is called ‘the premium’.

The cost (the premium) of an option - whether call or put - is determined by several factors, including the price of the underlying asset, the strike price, the time remaining on the option, and others.

(The time remaining is particularly important. Simple common sense suggests that if you have 90 days to exercise an option, your risk is lower than if you have only one day. In 90 days the price may well rise the several points needed to generate a profit. With only one day remaining, the odds are lower.)

Suppose it’s April 1, for example, and Apple (AAPL) has a market price of $27. Call options for June 30 are selling for $3 with a strike price of $30. You buy one contract for 100 shares.

So, if you held until expiration you either lose $300 ($3 x 100, the initial price of the contract not including commission), or buy the underlying stock at $30. If the current market price were $35 you’ve made $200. ($35 - ($30+$3) = $2 per share x 100 shares, ignoring commissions.)

When the market price of a share is above the strike price, the option holder is ‘in the money’. If the market price is lower, he’s ‘out of the money’.

Why buy PUTs instead of shorting a stock?

A ‘put’, by contrast, gives the option buyer the right to sell an asset at a certain price by a stated date. The right, not the obligation. Again important; you have the right and not the obligation; the risk you have is the premium you paid and that is all.

Puts are similar to ’shorting stock’, in this sense. Put buyers are betting the stock price will fall before the option expires.

In this case the market price must fall below the strike price in order to garner a profit from exercising the option. (Ignoring the cost of the put, for simplicity.) Under those circumstances, the option holder is ‘in the money’.

For example, take the same situation as above but let the option be a put. If the market price falls to, say $25, your profit would be:

First, $3 x 100 = $300 = Cost of put, excluding commissions.

Then, buy 100 shares at $25 per share = $2,500 to repay broker ‘loan’ (since shorting stock involves borrowing shares you don’t own, then repaying later).

Finally, sell 100 shares at Strike price = $30, 100 x $30 = $3,000

Therefore, your profit = ($3000 - $2500) - ($300) = $200.

(Actually, the broker takes care of all the underlying mechanics. The investor merely orders the trades at a given time and date.)

Remember that options trading is very risky and you may lose all your premium but the returns are wonderful