Our newsletter readership is always growing, so many readers are new in any given week. It is good sometimes to get down to the basics of option trading for those people who might be unfamiliar with the subject. That’s what we’ll do today by discussing the trading of stock options for profit.
Many kinds of investors and traders will find trading options profitable and satisfying once they try them. I hope this article stimulates your interest in doing so.
Some people who have never tried options may have shied away because they believe they are complicated. And while the nuances can be complex, the basics are simple. They can easily be understood by comparing options to some everyday items with which we are all familiar.
First, there exist exactly two types of stock options. One type is referred to as the call option. The second type is the put option. We’ll look at the call today.
The call is the option to buy stock. The everyday item that the call option resembles is a sale coupon. Here’s an example. You see a coupon online or in a newspaper (remember those?) that offers a latte from your favorite coffee chain for $6.00. Latte prices are volatile, and $6.00 is a good price right now. The coupon is good through the end of the month. You save the coupon.
You now have the ability, any time through the end of the month, to head to the coffee shop, turn over the coupon and the $6.00 and receive the latte. You can choose to do that; or you can choose not to. It is your option.
You pass the coffee shop on your way home. Lattes are posted at $6.00. No point in turning in the coupon.
You pass it again in a week. Lattes are now $7.00. Now the coupon is more valuable. You can turn it in today and save $1.00. You think, “What if lattes go up even more? I’ll wait a while.”
Over the weekend, the Brazil coffee crop fails. On Monday, latte prices are up to $15. And people are still buying lattes. In fact, they are standing in line to buy them, fearful that latte prices could go up even more before they get one. Now that coupon is really interesting. You could go into the shop, turn in the coupon and buy the now-$15 latte for $6. You could then go out to the people in line and sell one of them the latte for the going rate of $15, making a $9 profit.
While standing there congratulating yourself on this, another thought occurs to you. Why wait in line and buy the coffee at all? Why not just sell the coupon to one of the other people in line? They are more than willing to pay you $9 for it in order to save that amount and ensure that they have their price locked in. So, you sell it.
You just made an option trade. You had the right to buy the latte at a fixed price. The right was good for a fixed period of time. You could have exercised the option (bought the latte at the $6 price). You could have then kept the latte, or you could have sold it to someone else. But in the end, you made a profit by selling that right and never touching the latte at all.
Now add one small change: the coupon was not free, originally. You had to pay $1 for it, which you were willing to do because you thought there was a good chance that coffee prices would rise. In this example, it turned out to be well worth the price. A $1 investment turned into $9.
It could have gone differently. It might have been the case that the latte prices never changed before the end of the month. The coffee crop might have failed a day after the coupon expired. In that case, you would have been right in your belief that latte prices would rise, but the timing was off. You would be out a dollar and have to hope for better luck next time.
Here is the correspondence between the latte example and a call option on a $6 stock.
The latte, which in the stock option example corresponds to a share of stock, is called the underlying asset, or just the underlying for short.
The $6 price at which you had the right to buy the latte is called the strike price, or just the strike.
The date on which the offer ended is called the expiration date (some say expiry date).
The $1 price that you paid for the coupon/option is called the premium.
So in this example of a call option, you paid $1 (the premium) for the right to buy a latte or a share of stock (the underlying asset) at a fixed price of $6 (the strike price). The coupon/option was good through the end of the month (the expiration date).
See? Call Options are not that complicated.
Next time we’ll do the same with Put options.