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What Are Options? Buying Call Options. Selling Call Options.
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Options Basics
Options are not the same as stocks, though they’re linked to stocks. Options are binding contracts that give you the right to buy or sell a certain stock, at a set price, within a predefined window of opportunity. Note the name: option. You have the option to buy or sell the stock, but you’re not obligated. You have the freedom to pull the trigger, or to walk away. Essentially, when you buy options, you’re calling dibs on a certain stock price, and you’re paying for the privilege of having it frozen there for a little while – usually a few months.
There are two kinds of options: calls and puts. Buyers of call options expect the underlying stock to go up in price. Buyers of puts expect the underlying stock price to go down. Options can be attractive investments because they allow knowledgeable traders to make money both when stocks go up, and when they go down. You can both buy and sell call and put options.
There are four basic elements to every options contract: the stock it’s based on; the strike price; the expiration date; and the price of the option itself. The stock is whatever optionable stock you choose. The strike price is the price at which you can buy that underlying stock. The expiration date is the date by which your purchase rights expire; it falls on the third Friday of the expiration month. Stock options are listed with several potential strike prices and expiration months. The price of the option is the price you pay for the privilege of getting to buy your chosen stock, at your chosen strike price, within your chosen time frame.
Buying Call Options
Let’s say it’s June, XYZ is trading at $10 a share and you think it will go much higher by August. You don’t have the money to buy 100 XYZ stock shares at $10 a share, but the XYZ August 12.50 options calls are selling for $2 a contract. You see that one options contract controls 100 shares of stock. You choose to buy one XYZ August $12.50 call option at $2 a contract. You pay $200 -- $2 x 100 shares.
Your $200 buys you the right to buy 100 shares of XYZ stock at $12.50 a share anytime between now and the third Friday in August, when your contract will expire.
A week later XYZ stock shoots up to $16 a share. Congratulations! Do you exercise your option now and buy 100 shares of XYZ stock at $12.50 a share? Usually not. Wouldn’t you be making a profit? Yes – barely. You’d be making $350, minus the $200 you paid for the options, minus commissions for the stock trades. But why do all that -- look at the price of your XYZ options! They’ve also risen – let’s say, to $4 a contract – $400 minus the $200 you paid for the options = $200 profit in one week!
You see, when the underlying stocks rise in price, the value of your call options usually rise as well – and since the options cost far less, you can afford to load up on them. Translation: Options can make you a lot of money, very quickly, with only a small initial investment. But only if the price of the call option rises high enough – and within the timeframe you chose!
Here’s the other potential call option scenario, this one not so pretty: You choose to buy one XYZ August $12.50 option contract at $2 a contract. You pay $200. The price of XYZ stock plunges to $5 a share – far below your strike price. It stays there well into July. You’re now faced with a hard choice – sell your options for a big loss while you still can, or ride it out, hoping that the stock will rebound. If you still hold your contract on the third Friday in August, it will expire worthless – and you’ve lost the whole $200!
This possibility is why many brokerage firms advise their novice clients to avoid options trading – at least until they learn enough to assume these risks knowledgeably.
Selling Call Options
Say you still want to trade options, but you’re a little scared of that “expire worthless” stuff. You can choose a more conservative way of trading options, which is to sell, or write, an options call. How do you sell option calls?
Let’s say you own 100 shares of XYZ stock in June. You’ve watched it sit there all spring and it’s stuck at $10 a share. You don’t have much hope that it’s going to go up anytime soon, but you don’t like to let it just sit there.
You look at the XYZ options listings and see that the XYZ August $12.50 contract is selling for $2. You decide to sell one XYZ August $12.50 call for $2, and you receive a premium of $200. If you’re right, and XYZ stays stuck at $10 a share, you’ve managed to get a little profit from it anyway. If XYZ goes down, you’ve got that $200 premium to cushion the loss. Either way, you keep both the $200 premium and your stock.
The only risk you’re taking here is the potential loss of profit if XYZ suddenly goes up. For example, if XYZ shoots up to $25 a share anytime before the third Friday in August, you’ll be called out – stock lingo for, “you promised to sell your XYZ at $12.50 a share, and we’re taking you up on it.” You keep your $200 premium, and any profit that selling at $12.50 a share might get you, but you lose the additional profit you could have made by selling your stock at $25 a share.
Related articles: Buying and selling put options,
Best brokerages for Options Trading in 2012
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