After your have been investing in the stock market for a while, you might ask yourself how you can go to the next level.
Options are a good start. They are not too hard to understand and are easy to use.
Options give you the right, the choice, to buy or sell a stock at a predetermined price.
However, there is two versions:
– European: With this version, you can only exercise your right on a predetermined date.
– American: With this version, you can exercise the option any time before the predetermined date.
We can conclude that the American version is better than the European one.
Obviously, having the choice to invoke an option has a cost which, in the case of options, is called premiums.
As I said in the introduction you have the choice of buying or selling.
A call option gives you the right but not the obligation to buy a stock at a predetermined price in exchange for a premium.
On the other hand, a put option gives you the right to do the opposite, to sell stocks.
An interesting aspect of options, is that you can not only buy some, but also sell options.
Let’s take some examples:
Example 1: Call option
There is a call option for the stock of Tesla that is selling for 5$, ending the third Friday of April.
By the way as I’m writing we are in march.
Any time before that date you can buy the stock for 650$.
The stock is selling at the moment for the same price (so you have no advantage of using your option at this time).
Magic happens when the stock price increase.
If the stock price reaches 670$, you can exercise your right, buy it for 650$ and sell it for the market price (670$).
Which gives you a net profit of 15$ per share (20$ minus the cost of the option).
Example 2: Put option
Let’s take the same numbers but imagine that the stock price dropped from 650$ to 630$.
This time you sell the stocks for 650$ while the stock price has dropped to 530$, leaving you with the same profit of 15$.
In other words, a call option purchaser profits from an increase of a stock price while a put option purchaser profits from a decrease in stock price.
In the examples above, we saw the buyer’s side, but now let’s see the seller’s side, also known as, the short position.
They can be distinguished simply by taking into account their responsibility.
The only thing a buyer can lose is the premium, the cost of the option.
However, the seller could get in some way unlimited loss. In the case of a put option, the seller losses end until the stock price goes to zero.
While, in the case of a call option, there is no end because the stock price can go up indefinitely.
A simple strategy
Let’s say you already have stocks of Company X selling for 35$ and you expect you stock price to increase.
You can sell a put option of 5$ with an exercise price of 35$. The buyer will never exercise his option if the stock price goes up.
On the other side, you will be better off since you will benefit from the increase in the price of your shares and also from the payment of the premium.
You might say “Yeah, but no, it’s too risky to do that for 5$”.
Well, that could be beneficial, as options are sold in lots of 100 shares, so your profit would actually be $ 5 X 100 = $ 500.