Learn Stock Option Trading
Stock options trading refers to trading of contracts to buy (or sell) a stock for a certain price at a certain time in the future. Buyers of stock options have the right to buy the stock at the specified price, but they are not obligated to exercise their option. Sellers of options have the obligation to sell the underlying stock if the buyer of the option wishes to exercise it.
Call Options
A contract to buy is called a 'call option'. The buyer of a call option hopes the price of the underlying stock will rise, allowing him to buy it at less than market value. The seller of the call option expects that the price of the stock will not rise, or at least is willing to accept a partial loss of profits made from selling the call option.
For example: An investor buys a call option on ABC with a 'strike price' (the price the stock can be bought) of Rs 500. The current price of ABC stocks is Rs 400 and the cost of the call is Rs 50. If the price rises above Rs 550 (strike price + cost of call) the buyer could exercise his right to buy and make a profit by reselling on the open market. The seller would still gain from the increase in price from Rs 400 to Rs 550 plus the Rs 50, he made by selling the call. If the price remains below Rs 550 the call would not be exercised and the seller would profit by Rs 50 per share and the buyer would lose his Rs 50 per share.
Stock option trading is permitted on select stocks. The stock options (buy/sell) detail the name of the stock, the strike price (the price the stock can be bought or sold at), the expiration date and the premium (the price of the option itself). After the expiration the option cannot be exercised and is worthless. Options have a value and are actively traded. An option to buy ABC, for example, is listed like this:
ABC Jan '08 225 Call at Rs 20
This tells us that an option to buy 1 share of ABC at Rs 225 before the settlement day ie Thursday in January 2008 can be bought for Rs 20. Options usually expire on the Last Thursday of the specified month, and they are usually traded in lots of 100 or something like that. To buy this particular option you would have to pay Rs 2000 (plus brokerage fees).
Put Options
An option to sell a stock is called a 'put option'. This gives the holder the right (but not the obligation) to sell a particular stock within a certain time period at a certain price. In this situation the buyer is expecting the price of the stock to fall but does not want to sell outright in case the price rebounds. The seller feels that the price is stable or is willing to acquire the stock at the low price.
For example: An investor buys a put option on ABC with a 'strike price' (the price the stock can be sold) of Rs 350. The current price of Microsoft is Rs 400 and the cost of the put is Rs 50. If the price falls below Rs 300 (strike price + cost of put) the buyer could exercise his right to sell at a higher price than market. The seller would have to buy the stock at the higher-than-market price but any losses are offset by the Rs 50 he made by selling the put. If the price remains above Rs 300 the put would not be exercised and the seller would profit by Rs 50 per share and the buyer would lose his Rs 50 per share.
Principles of Stock Option Trading
As can be seen, stock option trading can be used to protect against loss or as an investment opportunity in their own right. They are generally used as part of a stock trading strategy which combines the purchase of stock with the purchase of options.
For example, in a bull (rising) market you could buy stocks and call options and sell put options. This allows you to take full advantage of rising stock prices – the stocks you buy will rise in value, the call options will allow you to buy stock at less than market prices, and if the market dips and the buyer of your put option exercises it, you can pick up additional stocks at low prices. If the buyer does not exercise the option, you make money from the sale of the option.
Conversely, in a bear market, you can sell stocks, sell calls, and buy puts to limit losses and generate profits. Unstable markets can use a mixture of puts and calls to maximize profit potential.
