Options puts and calls for dummies
Which means the person selling you the contract is actually giving you that right. In both scenarios you are buying low and selling high! Now when I say you are buying and selling shares, it's not exactly correct. That's called an Option Assignment. And your brokerage firm will charge you a small fee for handling the nitty gritty transactions in the back end.
Option Premium The one thing we didn't talk about so far is how much does it cost to buy an option contract? That depends on two factors. How close the current market price is to the strike price and how much time is left before the option expires. These two concepts are called Intrinsic Value and Time Value. A Call Option is said to have intrinsic value if the current market price is above the strike price.
The rest of the option price is the Time Value. A quick side note about how option premiums are stated. When you see an option price quote, you will typically see the price divided by It's stated that way because one option controls shares.
Don't be confused or mislead and buy more options than you can handle! For a Put Option, obviously the Intrinsic Value would be based on how much lower the market price is relative to the strike price. Time Decay An important factor to consider is the decay of time.
The Intrinsic Value doesn't decay, just the Time Value. Buying and Selling Options All this discussion was assuming the fact that you would keep the option contract until expiration. But the fact is you may not want to. In reality many people do not buy and hold the option that long. If they see an increase in the option they bought they will most likely sell the option and take their profit. Now you know that as time proceeds the decay in Time Value will decrease the value of your option.
So the only way to make money is to hope that the underlying stock moves in your favour. But if IBM's market price increases as well, the decay in time value may be offset. You can probably guess by now that the closer the market price is to the strike price, the more the option is worth. Now you can wait and see what happens on May 15th, but if you just wanted to take advantage of a short term price swing you can take your profits right now and run.
This section about reading options chains has been out dated, but it is still worthwhile to read through because you may still encounter these in various other websites. Click here to find out the latest method of reading options chains. Now that you know so much about options, lets talk about how to find them and how to interpret what you see.
You can look at the diagram below or go directly to Yahoo by opening another browser page and entering the URL http: As you can see there is a table like the one below: The red circle indicates this is for May The first column shows all the available strike prices. The green circle shows a weird looking symbol.
It's certainly not the symbol for IBM, but it looks similar. There is a standard for listing option quotes which you can see by going to the cheat sheet see link on the right hand navigation. You can probably figure out the rest of the circles if you've seen stock quotes.
A couple of things to point out is the pricing standard and the highted area. It is divided by and then listed. The volume however, has not been divided by anything! It really is The final thing to note is the area highlighted in yellow. Remember we talked about Intrinsic Value? The yellow highlighted options are referred to as "In the money" options.
Buyer Beware Until now I've just been giving pure facts about options. Now I'm going to give some advice. You have to be very careful when trading options.
People often tout the upside to options investing while playing down the risks involved. If you watch T. While it is true that you can realize tremendous profits, the chances of you realizing tremendous losses are just as great.. Even the best and brightest investment professionals cannot predict price movement especially over the short term. A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration.
The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long position in it. The advantage of buying a put over short selling the asset is that the option owner's risk of loss is limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller's loss.
The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already received. Puts can be used also to limit the writer's portfolio risk and may be part of an option spread.
That is, the buyer wants the value of the put option to increase by a decline in the price of the underlying asset below the strike price. The writer seller of a put is long on the underlying asset and short on the put option itself. That is, the seller wants the option to become worthless by an increase in the price of the underlying asset above the strike price. Generally, a put option that is purchased is referred to as a long put and a put option that is sold is referred to as a short put.
A naked put , also called an uncovered put , is a put option whose writer the seller does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock, but only if the price is low enough. If the buyer fails to exercise the options, then the writer keeps the option premium as a "gift" for playing the game. If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner buyer can exercise the put option, forcing the writer to buy the underlying stock at the strike price.
That allows the exerciser buyer to profit from the difference between the stock's market price and the option's strike price. But if the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless, and the owner's loss is limited to the premium fee paid for it the writer's profit. The seller's potential loss on a naked put can be substantial. If the stock falls all the way to zero bankruptcy , his loss is equal to the strike price at which he must buy the stock to cover the option minus the premium received.
The potential upside is the premium received when selling the option: During the option's lifetime, if the stock moves lower, the option's premium may increase depending on how far the stock falls and how much time passes. If it does, it becomes more costly to close the position repurchase the put, sold earlier , resulting in a loss.
If the stock price completely collapses before the put position is closed, the put writer potentially can face catastrophic loss. In order to protect the put buyer from default, the put writer is required to post margin. The put buyer does not need to post margin because the buyer would not exercise the option if it had a negative payoff. A buyer thinks the price of a stock will decrease. He pays a premium which he will never get back, unless it is sold before it expires. The buyer has the right to sell the stock at the strike price.
The writer receives a premium from the buyer. If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer's profit is the premium. A put option is said to have intrinsic value when the underlying instrument has a spot price S below the option's strike price K.