If you anticipate a certain directional movement in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity. The decision as to what type of option to buy is dependent on whether your outlook for the respective security is positive (bullish) or negative (bearish). If your outlook is positive, buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value. Conversely, if you anticipate downward movement, buying a put option will enable you to protect against downside risk without limiting profit potential. Purchasing options offer you the ability to position yourself accordingly with your market expectations in a manner such that you can both profit and protect with limited risk.
Buying an XYZ July 50 call option gives you the right to purchase 100 shares of XYZ common stock at a cost of $50 per share at any time before the option expires in July. The right to buy stock at a fixed price becomes more valuable as the price of the underlying stock increases.
Assume that the price of the underlying shares was $50 at the time you bought your option and the premium you paid was 3.50 (or $350). If the price of XYZ stock climbs to $55 before your option expires and the premium rises to 5.50, you have two choices in disposing of your in-the-money option:
(1) You can exercise your option and buy the underlying XYZ stock for $50 a share for a total cost of $5,350 (including the option premium) and simultaneously sell the shares on the stock market for $5,500 yielding a net profit of $ 150, or
(2) You can close out your position by selling the option contract for $550, collecting the difference between the premium received and paid, $200. In this case, you make a profit of 57% (200/350), whereas your profit on an outright stock purchase, given the same price movement, would be only 10% (55-50/50). Commissions costs may impact your returns.
The profitability of similar examples will depend on how the time remaining until expiration affects the premium. Remember, time value declines sharply as an option nears its expiration date. Also influencing your decision will be your desire to own the stock.
If the price of XYZ instead fell to $45 and the option premium fell to .88, you could sell your option to partially offset the premium you paid. Otherwise, the option would expire worthless and your loss would be the total amount of the premium paid or $350. In most cases, the loss on the option would be less than what you would have lost had you bought the underlying shares outright, $260.50 versus $500 in this example.
Put options may provide a more attractive method than shorting stock for profiting on stock price declines, in that, with purchased puts, you have a known and predetermined risk. The most you can lose is the cost of the option. If you short stock, the potential loss, in the event of a price upturn, is unlimited.
Another advantage of buying puts results from your paying the full purchase price in cash at the time the put is bought. Shorting stock requires a margin account, and margin calls on a short sale might force you to cover your position prematurely, even though the position still may have profit potential. As a put buyer, you can hold your position through the option's expiration without incurring any additional risk.
Buying an XYZ July 50 put gives you the right to sell 100 shares of XYZ stock at $50 per share at any time before the option expires in July. This right to sell stock at a fixed price becomes more valuable as the stock price declines.
Assume that the price of the underlying shares was $50 at the time you bought your option and the premium you paid was 4 (or $400). If the price of XYZ falls to $45 before July and the premium rises to 6, you have two choices in disposing of your in-the-money put option:
1.You can buy 100 shares of XYZ stock at $45 per share and simultaneously exercise your put option to sell XYZ at $50 per share, netting a profit of $100 ($500 profit on the stock less the $400 Option premium).
2.You can sell your put option contract, collecting the difference between the premium paid and the premium received, $200 in this case.
If, however, the holder has chosen not to act, his maximum loss using this strategy would be the total cost of the put option or $400. The profitability of similar examples depends on how the time remaining until expiration affects the premium. Remember, time value declines sharply as an option nears its expiration date.
If XYZ prices instead had climbed to $55 prior to expiration and the premium fell to 1.50, your put option would beout-of-the-money . You could still sell your option for $150, partially offsetting its original price. In most cases, the cost of this strategy will be less than what you would have lost had you shorted XYZ stock instead of purchasing the put option, $250 versus $500 in this case.
This strategy allows you to benefit from downward price movements while limiting losses to the premium paid if pricesincrease.
This introductory information should be read in conjunction with the basic option disclosure document, titled Characteristics and Risks of Standardized Options, which outlines the purposes and risks of option transactions. Despite their many benefits, options are not suitable for all investors. Individuals should not enter into option transactions until they have read and understood the risk disclosure document which can be obtained at www.cboe.com.
Options allow you to participate in price movements without committing the large amount of funds or margin needed to buy stock outright or sell short. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing options, to earn premium income.
Whether you are a conservative or growth-oriented investor, or even a short-term, aggressive trader, your investment advisor can help you select an appropriate options strategy. The strategies presented here are the most basic strategies and can serve as building blocks for the more complex strategies available. An investor who desires to utilize options should have well-defined investment objectives suited to his particular financial situation and a plan for achieving these objectives. The successful use of options requires a willingness to learn what they are, how they work, and what risks are associated with particular options strategies.
Armed with an understanding of the fundamentals, and with additional information and assistance that is readily available from many brokerage and online firms and other sources, individuals seeking new investment opportunities in today's markets will find options trading challenging, often fast moving, and potentially rewarding.