Lesson #1: What are Options? / Lesson #2: How options are priced / Lesson #3: Calls and Puts / Lesson #4: How options increase in value / Lesson #5: Time and Options / Lesson #6: Strike Price / Lesson #7: In, At and Out of the Money / Lesson #8: Option Risks / Lesson #9: Writing Options
When it comes to buying options, you can purchase two types. The first is best suited if you expect the stock to rise in price and second if you expect the stock to decline in value.
Call Options
You purchase call options if you believe the stock price will rise!
When you purchase a call option, you purchase the right but not the obligation to buy the stock off the individual writing the option at the predetermined Strike price. If at expiration date, the stock price is higher than your strike price, you can force the writer of the option to sell the stock to you at the lower strike price.
Example: XYZ stock is selling for $20.50. You buy a call option in the money with a Strike price of $20.00 for $1.50. At the expiration date of the option, the stock is worth $25.00. At this point, you can choose to exercise the option and force the underwriter to sell XYZ stock to you for $20.00. You could then turn around and sell the stock for $25.00. You make a profit of $5.00 minus the option fee of a $1.50 and end up with a net profit of $3.50 per stock option.
If the stock decreases in value and falls below the $20.00 Strike Price, you are under no obligation to buy the stock and can walk away from the deal. At this point, all you will lose is your initial option purchase of $1.50.
| Summary of Call Options |
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However, exercising the option and buying the stock may not be the best investment move. Because of the significant increase in the value of this stock, the delta is 50. This means if the stock increases by $5.00, the value of the option will increase by $2.50.
Provided their is still time left before the option expires, you can choose to sell the option for its current value of $3.00. This option did lose some value because of time cost.
This is what make options interesting. If you exercised the option and bought the stock for $20.00 and made a profit of $3.50 (after subtracting the option price), you would have made a profit of about 17%, a respectable return. However, if you sold the option before it expired for $3.00, you would have made a 100% return off your initial investment of $1.50.
So what happens if the stock price goes down. Since you are the one who bought the option, you are the only one who can exercise it. The individual who sold you the option can't force you to buy the stock and the option expires worthless. You lose the amount that you paid to buy the option. Note: you may be able to recoup some of your investment, if you choose to sell the option before expiry date. It will be worth significantly less than you paid for it.
Put Options
You purchase Put Options if you believe the stock will decrease in value.
| Summary of Put Options |
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Put options are a strange breed of cat and sometimes people have a difficult time wrapping their head around them. When you buy a Put Option, you have purchased the right, but not the obligation, to sell a particular stock to the writer of the option at the Strike Price. In this play, you are hoping the price of the stock goes down, allowing you to sell the stock at a higher price than its current value.
Example: XYZ stock is selling for $20.50. You buy a put option out of the money with a Strike price of $20.00 for $1.00. At the expiration date of the option, the stock is worth $15.00. At this point, you can choose to exercise the option and force the underwriter to buy XYZ stock to you for $20.00. Since you can purchase the stock for just $15.00 you make a profit of $5.00 minus the option fee of $1.00 per stock. Your net profit on the deal is $4.00.
If the stock increases above the $20.00 Strike Price, you are under no obligation to sell the stock and can walk away from the deal. At this point, all you will lose is your initial option purchase of $1.00.
However, instead of exercising the option you choose to sell it before expiry date. With a delta of 50, the option would be worth approximately $2.50 once time is factored out of the value of the option. Since the option only cost you $1.00, this would leave you with a 150% return on the play.